Edgar Filing: MACKINAC FINANCIAL CORP /MI/

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2014

o TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from <> to <>

Commission file number: 0-20167

MACKINAC FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

MICHIGAN		38-2062816
(State or other jurisdiction of		(I.R.S. Employer Identification No.)
incorporation or organization)

130 SOUTH CEDAR STREET, MANISTIQUE, MI		49854
(Address of principal executive offices)		(Zip Code)

Registrant’s telephone number, including area code: (888) 343-8147

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 periods that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

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

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

Large Accelerated Filer o

Accelerated Filer o

Non-accelerated Filer o

Smaller reporting company x

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

As of June 30, 2014, there were outstanding 5,527,690 shares of the registrant’s common stock, no par value.

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MACKINAC FINANCIAL CORPORATION

INDEX

		Page No.

PART I.	FINANCIAL INFORMATION

Item 1.	Financial Statements

	Condensed Consolidated Balance Sheets - June 30, 2014 (Unaudited), December 31, 2013 and June 30, 2013 (Unaudited)	1

	Condensed Consolidated Statements of Operations — Three and Six Months Ended June 30, 2014 (Unaudited) and June 30, 2013 (Unaudited)	2

	Condensed Consolidated Statements of Comprehensive Income — Three and Six Months Ended June 30, 2014 (Unaudited) and June 30, 2013 (Unaudited)	3

	Condensed Consolidated Statements of Changes in Shareholders’ Equity — Three and Six Months Ended June 30, 2014 (Unaudited) and June 30, 2013 (Unaudited)	3

	Condensed Consolidated Statements of Cash Flows - Six Months Ended June 30, 2014 (Unaudited) and June 30, 2013 (Unaudited)	4

	Notes to Condensed Consolidated Financial Statements (Unaudited)	5

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	32

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	42

Item 4.	Controls and Procedures	45

PART II.	OTHER INFORMATION

Item 1.	Legal Proceedings	46

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	46

Item 6.	Exhibits and Reports on Form 8-K	46

SIGNATURES		47

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MACKINAC FINANCIAL CORPORATION

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

CONSOLIDATED BALANCE SHEETS

(Dollars in Thousands)

	June 30,			December 31,			June 30,
	2014			2013			2013
	(Unaudited)						(Unaudited)
ASSETS

Cash and due from banks	$	20,744		$	18,216		$	26,216
Federal funds sold	2			3			3
Cash and cash equivalents	20,746			18,219			26,219

Interest-bearing deposits in other financial institutions	235			10			10
Securities available for sale	47,374			44,388			47,307
Federal Home Loan Bank stock	3,060			3,060			3,060

Loans:
Commercial	374,565			359,368			343,561
Mortgage	113,332			110,663			98,559
Consumer	15,043			13,801			13,435
Total Loans	502,940			483,832			455,555
Allowance for loan losses	(5,097		)	(4,661		)	(5,177		)
Net loans	497,843			479,171			450,378

Premises and equipment	9,790			10,210			10,536
Other real estate held for sale	1,947			1,884			2,481
Deferred tax asset	9,097			9,933			8,367
Other assets	5,777			5,925			5,143

TOTAL ASSETS	$	595,869		$	572,800		$	553,501

LIABILITIES AND SHAREHOLDERS’ EQUITY

LIABILITIES:
Deposits:
Noninterest bearing deposits	$	73,732		$	72,936		$	64,736
NOW, money market, interest checking	148,242			149,123			146,203
Savings	15,658			13,039			12,229
CDs<$100,000	143,140			140,495			134,767
CDs>$100,000	23,151			23,159			25,091
Brokered	80,093			67,547			64,881
Total deposits	484,016			466,299			447,907

Borrowings	42,087			37,852			35,925
Other liabilities	3,289			3,400			3,149
Total liabilities	529,392			507,551			486,981

SHAREHOLDERS’ EQUITY:
Preferred stock - No par value:
Authorized - 500,000 shares , none issued and outstanding	—			—			4,000
Common stock and additional paid in capital - No par value
Authorized - 18,000,000 shares
Issued and outstanding - 5,527,690; 5,541,390 and 5,557,859 respectively	53,703			53,621			53,934
Retained earnings	12,325			11,412			8,156
Accumulated other comprehensive income	449			216			430

Total shareholders’ equity	66,477			65,249			66,520

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY	$	595,869		$	572,800		$	553,501

See accompanying notes to condensed consolidated financial statements.

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MACKINAC FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Dollars in Thousands, Except per Share Data)

	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2014		2013		2014		2013
	(Unaudited)				(Unaudited)
INTEREST INCOME:
Interest and fees on loans:
Taxable	$	6,373	$	6,014	$	12,654	$	11,903
Tax-exempt	—		28		23		55
Interest on securities:
Taxable	244		241		481		481
Tax-exempt	14		6		27		13
Other interest income	32		32		80		63
Total interest income	6,663		6,321		13,265		12,515

INTEREST EXPENSE:
Deposits	800		886		1,622		1,763
Borrowings	204		166		391		327
Total interest expense	1,004		1,052		2,013		2,090

Net interest income	5,659		5,269		11,252		10,425
Provision for loan losses	191		100		374		475
Net interest income after provision for loan losses	5,468		5,169		10,878		9,950

OTHER INCOME:
Deposit service fees	192		175		349		337
Income from loans sold on the secondary market	139		279		242		578
SBA/USDA loan sale gains	166		554		548		663
Mortgage servicing income	89		182		102		285
Other	64		61		100		146
Total other income	650		1,251		1,341		2,009

OTHER EXPENSE:
Salaries and employee benefits	2,523		2,375		5,064		4,681
Occupancy	546		363		1,084		745
Furniture and equipment	303		255		622		525
Data processing	288		268		574		533
Advertising	123		111		230		215
Professional service fees	276		320		607		545
Loan and deposit	83		45		162		118
Writedowns and losses on other real estate held for sale	14		87		14		89
FDIC insurance assessment	90		95		175		200
Telephone	82		63		164		145
Other	570		541		1,309		1,038
Total other expenses	4,898		4,523		10,005		8,834

Income before provision for income taxes	1,220		1,897		2,214		3,125
Provision for income taxes	414		637		748		1,052

NET INCOME	806		1,260		1,466		2,073

Preferred dividend and accretion of discount	—		63		—		200

NET INCOME AVAILABLE TO COMMON SHAREHOLDERS	$	806	$	1,197	$	1,466	$	1,873

INCOME PER COMMON SHARE:
Basic	$	.15	$	.22	$	.27	$	.34
Diluted	$	.14	$	.22	$	.26	$	.34

See accompanying notes to condensed consolidated financial statements.

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MACKINAC FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS COMPREHENSIVE INCOME

(Dollars in Thousands)

(Unaudited)

	Three Months Ended						Six Months Ended
	June 30,			June 30,			June 30,			June 30,
	2014			2013			2014			2013

Net income	$	806		$	1,260		$	1,466		$	2,073

Net change in net unrealized gains and losses on securities available for sale:
Unrealized gains (losses) arising during the period	150			(832		)	345			(763		)
Less: reclassification adjustment for gains included in net income	—			15			—			15
Net securities gain (loss) during the period	150			(817		)	345			(748		)
Tax effect	(45		)	277			(112		)	254
Other comprehensive income (loss)	105			(540		)	233			(494		)

Total comprehensive income	$	911		$	720		$	1,699		$	1,579

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

(Dollars in Thousands)

(Unaudited)

	Three Months Ended								Three Months Ended
	June 30,								June 30,
	2014								2013
			Common			Total						Common			Total
	Preferred		Shareholders’			Shareholders’			Preferred			Shareholders’			Shareholders’
	Stock		Equity			Equity			Stock			Equity			Equity

Balance, beginning of period	$	—	$	65,730		$	65,730		$	11,000		$	62,039		$	73,039

Net income for period	—		806			806			—			1,260			1,260
Net unrealized gain (loss) on securities available for sale	—		105			105			—			(540		)	(540		)
Total comprehensive income	—		911			911			—			720			720
Stock compensation	—		113			113			—			75			75
Dividend on common stock	—		(277		)	(277		)	—			(222		)	(222		)
Repurchase of common stock	—		—			—			—			(29		)	(29		)
Redemption of Preferred Series A stock	—		—			—			(7,000		)	—			(7,000		)
Dividend on preferred stock	—		—			—			—			(63		)	(63		)
Balance, end of period	$	—	$	66,477		$	66,477		$	4,000		$	62,520		$	66,520

	Six Months Ended								Six Months Ended
	June 30,								June 30,
	2014								2013
			Common			Total						Common			Total
	Preferred		Shareholders’			Shareholders’			Preferred			Shareholders’			Shareholders’
	Stock		Equity			Equity			Stock			Equity			Equity

Balance, beginning of period	$	—	$	65,249		$	65,249		$	11,000		$	61,448		$	72,448

Net income for period	—		1,466			1,466			—			2,073			2,073
Net unrealized gain (loss) on securities available for sale	—		233			233			—			(494		)	(494		)
Total comprehensive income	—		1,699			1,699			—			1,579			1,579
Stock compensation	—		225			225			—			183			183
Dividend on common stock	—		(553		)	(553		)	—			(444		)	(444		)
Repurchase of common stock	—		(143		)	(143		)	—			(46		)	(46		)
Redemption of Preferred Series A stock	—		—			—			(7,000		)	—			(7,000		)
Dividend on preferred stock	—		—			—			—			(200		)	(200		)
Balance, end of period	$	—	$	66,477		$	66,477		$	4,000		$	62,520		$	66,520

See accompanying notes to condensed consolidated financial statements.

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MACKINAC FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in Thousands)

(Unaudited)

	Six Months Ended
	June 30,
	2014			2013
Cash Flows from Operating Activities:
Net income	$	1,466		$	2,073
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization	751			840
Provision for loan losses	374			475
Deferred income taxes, net	748			1,052
Gain on sales/calls of securities	—			(15		)
(Gain) on sale of loans sold to secondary market	(191		)	(458		)
Origination of loans held for sale in the secondary market	(11,170		)	(32,597		)
Proceeds from sale of loans in the secondary market	11,361			33,055
Loss (gain) on sale of premises, equipment, and other real estate held for sale	41			(25		)
Writedown of other real estate held for sale	2			114
Stock compensation	225			183
Change in other assets	149			72
Change in other liabilities	(111		)	99
Net cash provided by operating activities	3,645			4,868

Cash Flows from Investing Activities:
Net increase in loans	(19,354		)	(7,600		)
Net increase in deposits held at other banks	(225		)	—
Purchase of securities available for sale	(3,243		)	(4,974		)
Proceeds from maturities, sales, calls or paydowns of securities available for sale	504			476
Capital expenditures	(798		)	(501		)
Proceeds from sale of premises, equipment, and other real estate	742			1,329
Net cash (used in) investing activities	(22,374		)	(11,270		)

Cash Flows from Financing Activities:
Net increase in deposits	17,717			13,350
Net increase in borrowings	4,235			—
Repurchase of common stock	(143		)	(46		)
Dividend on common stock	(553		)	(444		)
Redemption of Preferred Series A	—			(7,000		)
Dividend on preferred stock	—			(200		)
Net cash provided by financing activities	21,256			5,660

Net increase (decrease) in cash and cash equivalents	2,527			(742		)
Cash and cash equivalents at beginning of period	18,219			26,961

Cash and cash equivalents at end of period	$	20,746		$	26,219

Supplemental Cash Flow Information:
Cash paid during the year for:
Interest	$	2,009		$	1,651
Income taxes	25			99

Noncash Investing and Financing Activities:
Transfers of Foreclosures from Loans to Other Real Estate Held for Sale	282			687
(net of adjustments made through the allowance for loan losses)

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MACKINAC FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The unaudited condensed consolidated financial statements of Mackinac Financial Corporation (the “Corporation”) have been prepared in accordance with generally accepted accounting principles for interim financial information and the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the six-month period ended June 30, 2014 are not necessarily indicative of the results that may be expected for the year ending December 31, 2014. The unaudited consolidated financial statements and footnotes thereto should be read in conjunction with the audited consolidated financial statements and footnotes thereto included in the Corporation’s Annual Report on Form 10-K for the year ended December 31, 2013.

In order to properly reflect some categories of other income and other expenses, reclassifications of expense and income items have been made to prior period numbers. The “net” other income and other expenses was not changed due to these reclassifications.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, and the valuation of deferred tax assets, mortgage servicing rights and other real estate held for sale.

Allowance for Loan Losses

The allowance for loan losses includes specific allowances related to commercial loans, when they have been judged to be impaired. A loan is impaired when, based on current information, it is probable that the Corporation will not collect all amounts due in accordance with the contractual terms of the loan agreement. These specific allowances are based on discounted cash flows of expected future payments using the loan’s initial effective interest rate or the fair value of the collateral if the loan is collateral dependent.

The Corporation continues to maintain a general allowance for loan losses for loans not considered impaired. The allowance for loan losses is maintained at a level which management believes is adequate to provide for possible loan losses. Management periodically evaluates the adequacy of the allowance using the Corporation’s past loan loss experience, known and inherent risks in the portfolio, composition of the portfolio, current economic conditions, and other factors. The allowance does not include the effects of expected losses related to future events or future changes in economic conditions. This evaluation is inherently subjective since it requires material estimates that may be susceptible to significant change. Loans are charged against the allowance for loan losses when management believes the collectability of the principal is unlikely. In addition, various regulatory agencies periodically review the allowance for loan losses. These agencies may require additions to the allowance for loan losses based on their judgments of collectability.

In management’s opinion, the allowance for loan losses is adequate to cover probable losses relating to specifically identified loans, as well as probable losses inherent in the balance of the loan portfolio as of the balance sheet date.

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MACKINAC FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Stock Compensation Plans

On May 22, 2012, the Company’s shareholders approved the Mackinac Financial Corporation 2012 Incentive Compensation Plan, under which current and prospective employees, non-employee directors and consultants may be awarded incentive stock options, non-statutory stock options, shares of restricted stock units (“RSUs”), or stock appreciation rights. The aggregate number of shares of the Company’s common stock issuable under the plan is 575,000, which included 392,152 option shares outstanding at that time. Awards are made at the discretion of management. Compensation cost equal to the fair value of the award is recognized over the vesting period.

The Corporation, in August 2012 and March 2014, granted Restricted Stock Units (“RSUs”) to members of the Board of Directors and Management. In August 2012, 148,500 RSUs were granted at a market value of $7.91 and will vest equally over a four year term. In exchange for the grant of these RSUs various previously issued stock option awards were surrendered. In March 2014, 52,774 RSUs were granted at a market value of $12.95, also vesting equally over a four year term. The RSUs were awarded at no cost to the employee. Compensation cost to be recognized over the four —year vesting periods, is $1.175 million and $.683 million, respectively. On August 31, 2013, the Corporation issued 37,125 shares of its common stock for vested RSUs. As of June 30, 2014, RSUs totaling 164,149 were unvested and unrecognized compensation expense was $1.270 million.

2. RECENT ACCOUNTING PRONOUNCEMENTS

In May 2014, the Financial Accounting Standards Board (FASB) issued guidance on the recognition of revenue from contracts with customers. Revenue recognition will depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance also requires disclosures regarding the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. The guidance permits two methods of adoption: retrospectively to each prior reporting period presented or retrospectively with the cumulative effect of initially applying the guidance recognized at the date of initial application. The guidance is effective January 1, 2017 and early adoption is not permitted. The company is currently evaluating the impact of the new guidance and the method of adoption in the consolidated financial results.

3. EARNINGS PER SHARE

Diluted earnings per share, which reflects the potential dilution that could occur if outstanding stock options were exercised and stock awards were fully vested and resulted in the issuance of common stock that then shared in our earnings, is computed by dividing net income by the weighted average number of common shares outstanding and common stock equivalents, after giving effect for dilutive shares issued.

The following shows the computation of basic and diluted earnings per share for the three and six months ended June 30, 2014 and 2013 (dollars in thousands, except per share data):

	Three Months Ended June 30,				Six Months Ended June 30,
	2014		2013		2014		2013
(Numerator):
Net income	$	806	$	1,260	$	1,466	$	2,073
Preferred stock dividends and accretion of discount	—		63		—		200
Net income available to common shareholders	$	806	$	1,197	$	1,466	$	1,873
(Denominator):
Weighted average shares outstanding - basic	5,527,690		5,556,133		5,529,290		5,557,842
Effect of dilutive stock options and vesting of restricted stock units	90,001		—		55,642		—
Weighted average shares outstanding - diluted	5,617,691		5,556,133		5,584,932		5,557,842
Income per common share:
Basic	$	.15	$	.22	$	.27	$	.34
Diluted	$	.14	$	.22	$	.26	$	.34

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MACKINAC FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

4. INVESTMENT SECURITIES

The amortized cost and estimated fair value of investment securities available for sale as of June 30, 2014, December 31, 2013 and June 30, 2013 are as follows (dollars in thousands):

			Gross		Gross
	Amortized		Unrealized		Unrealized			Estimated
	Cost		Gains		Losses			Fair Value

*June 30, 2014*

US Agencies - MBS	$	6,598	$	253	$	—		$	6,851
US Agencies	17,755		91		(258		)	17,588
Corporate Bonds	15,691		189		—			15,880
Obligations of states and political subdivisions	6,441		400		(2		)	6,839
Other	216		—		—			216

Total securities available for sale	$	46,701	$	933	$	(260	)	$	47,374

December 31, 2013

US Agencies - MBS	$	7,078	$	281	$	—		$	7,359
US Agencies	15,227		—		(372		)	14,855
Corporate Bonds	15,862		218		(1		)	16,079
Obligations of states and political subdivisions	5,893		202		—			6,095

Total securities available for sale	$	44,060	$	701	$	(373	)	$	44,388

June 30, 2013

US Agencies - MBS	$	7,491	$	354	$	—		$	7,845
US Agencies	15,172		74		(341		)	14,905
Corporate Bonds	18,557		161		(45		)	18,673
Obligations of states and political subdivisions	5,435		450		(1		)	5,884

Total securities available for sale	$	46,655	$	1,039	$	(387	)	$	47,307

The Corporation has evaluated gross unrealized losses that exist within the portfolio and considers them temporary in nature. The Corporation has both the ability and the intent to hold the investment securities until their respective maturities and therefore does not anticipate the realization of the temporary losses.

The amortized cost and estimated fair value of investment securities pledged to secure FHLB borrowings and customer relationships were $4.378 million and $4.530 million, respectively, at June 30, 2014.

5. LOANS

The composition of loans is as follows (dollars in thousands):

	June 30,		December 31,		June 30,
	2014		2013		2013

Commercial real estate	$	274,500	$	268,809	$	243,363
Commercial, financial, and agricultural	89,515		79,655		84,145
One to four family residential real estate	105,868		103,768		94,254
Construction :
Consumer	7,464		6,895		4,305
Commerical	10,550		10,904		16,053
Consumer	15,043		13,801		13,435

Total loans	$	502,940	$	483,832	$	455,555

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MACKINAC FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

5. LOANS (Continued)

An analysis of the allowance for loan losses for the six months ended June 30, 2014, the year ended December 31, 2013, and the six months ended June 30, 2013 is as follows (dollars in thousands):

	June 30,			December 31,			June 30,
	2014			2013			2013

Balance at beginning of period	$	4,661		$	5,218		$	5,218
Loans charged off	(115		)	(2,432		)	(616		)
Recoveries on loans previously charged off	177			200			100
Provision	374			1,675			475

Balance at end of period	$	5,097		$	4,661		$	5,177

In the first half of 2014, net recoveries were $62,000, compared to net charge-offs of $.516 million, or .23% of average loans, in the same period in 2013. In the first half of 2014, the Corporation recorded a provision for loan loss of $.374 million compared to $.475 million in the first half of 2013. The Corporation’s allowance for loan loss reserve policy calls for a measurement of the adequacy of the reserve at each quarter end. This process includes an analysis of the loan portfolio to take into account increases in loans outstanding and portfolio composition, historical loss rates, and specific reserve requirements of nonperforming loans.

A breakdown of the allowance for loan losses and recorded balances in loans at June 30, 2014 is as follows (dollars in thousands):

				Commercial,						One to four
Three Months Ended June 30, 2014	Commercial			financial and			Commercial			family residential			Consumer
Allowance for loan loss reserve:	real estate			agricultural			construction			real estate			construction			Consumer			Unallocated			Total
Beginning balance ALLR	$	1,756		$	1,572		$	41		$	391		$	16		$	114		$	993		$	4,883
Charge-offs	—			(3		)	—			(13		)	—			(17		)	—			(33		)
Recoveries	20			15			3			8			—			10			—			56
Provision	(146		)	85			(4		)	(41		)	(1		)	4			294			191
Ending balance ALLR	$	1,630		$	1,669		$	40		$	345		$	15		$	111		$	1,287		$	5,097

Six Months Ended June 30, 2014
Allowance for loan loss reserve:
Beginning balance ALLR	$	1,849		$	1,378		$	80		$	516		$	25		$	148		$	665		$	4,661
Charge-offs	(1		)	(65		)	—			(16		)	—			(33		)	—			(115		)
Recoveries	74			59			6			14			—			24			—			177
Provision	(292		)	297			(46		)	(169		)	(10		)	(28		)	622			374
Ending balance ALLR	$	1,630		$	1,669		$	40		$	345		$	15		$	111		$	1,287		$	5,097

At June 30,2014
Loans:
Ending balance	$	274,500		$	89,515		$	10,550		$	105,868		$	7,464		$	15,043		$	—		$	502,940
Ending balance ALLR	(1,630		)	(1,669		)	(40		)	(345		)	(15		)	(111		)	(1,287		)	(5,097		)
Net loans	$	272,870		$	87,846		$	10,510		$	105,523		$	7,449		$	14,932		$	(1,287	)	$	497,843

Ending balance ALLR:
Individually evaluated	$	189		$	1,110		$	—		$	118		$	—		$	21		$	—		$	1,438
Collectively evaluated	1,441			559			40			227			15			90			1,287			3,659
Total	$	1,630		$	1,669		$	40		$	345		$	15		$	111		$	1,287		$	5,097

Ending balance Loans:
Individually evaluated	$	609		$	1,744		$	—		$	622		$	—		$	64		$	—		$	3,039
Collectively evaluated	273,891			87,771			10,550			105,246			7,464			14,979			—			499,901
Total	$	274,500		$	89,515		$	10,550		$	105,868		$	7,464		$	15,043		$	—		$	502,940

Impaired loans, by definition, are individually evaluated.

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MACKINAC FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

5. LOANS (Continued)

A breakdown of the allowance for loan losses and recorded balances in loans at December 31, 2013 is as follows (dollars in thousands):

				Commercial,						One to four
	Commercial			financial and			Commercial			family residential			Consumer
Allowance for loan loss reserve:	real estate			agricultural			construction			real estate			construction			Consumer			Unallocated			Total
Beginning balance ALLR	$	3,267		$	692		$	125		$	980		$	—		$	—		$	154		5,218
Charge-offs	(1,539		)	(632		)	—			(141		)	—			(120		)	—			(2,432		)
Recoveries	92			56			2			26			2			22			—			200
Provision	29			1,262			(47		)	(349		)	23			246			511			1,675
Ending balance ALLR	$	1,849		$	1,378		$	80		$	516		$	25		$	148		$	665		$	4,661

Loans:
Ending balance	$	268,809		$	79,655		$	10,904		$	103,768		$	6,895		$	13,801		$	—		$	483,832
Ending balance ALLR	(1,849		)	(1,378		)	(80		)	(516		)	(25		)	(148		)	(665		)	(4,661		)
Net loans	$	266,960		$	78,277		$	10,824		$	103,252		$	6,870		$	13,653		$	(665	)	$	479,171

Ending balance ALLR:
Individually evaluated	$	99		$	891		$	—		$	103		$	—		$	18		$	—		$	1,111
Collectively evaluated	1,750			487			80			413			25			130			665			3,550
Total	$	1,849		$	1,378		$	80		$	516		$	25		$	148		$	665		$	4,661

Ending balance Loans:
Individually evaluated	$	649		$	1,830		$	—		$	385		$	—		$	42		$	—		$	2,906
Collectively evaluated	268,160			77,825			10,904			103,383			6,895			13,759			—			480,926
Total	$	268,809		$	79,655		$	10,904		$	103,768		$	6,895		$	13,801		$	—		$	483,832

A breakdown of the allowance for loan losses and recorded balances in loans at June 30, 2013 is as follows (dollars in thousands):

				Commercial,						One to four
Three Months Ended June 30, 2013	Commercial			financial and			Commercial			family residential			Consumer
Allowance for loan loss reserve:	real estate			agricultural			construction			real estate			construction		Consumer			Unallocated			Total
Beginning balance ALLR	$	2,964		$	847		$	118		$	990		$	—	$	13		$	105		$	5,037
Charge-offs	(21		)	(4		)	—			(6		)	—		(5		)	—			(36		)
Recoveries	29			30			1			6			—		10			—			76
Provision	(311		)	217			(22		)	(113		)	—		(5		)	334			100
Ending balance ALLR	$	2,661		$	1,090		$	97		$	877		$	—	$	13		$	439		$	5,177

Six Months Ended June 30, 2013
Allowance for loan loss reserve:
Beginning balance ALLR	$	3,267		$	692		$	125		$	980		$	—	$	—		$	154		$	5,218
Charge-offs	(456		)	(76		)	—			(13		)	—		(71		)	—			(616		)
Recoveries	41			33			2			11			—		13			—			100
Provision	(191		)	441			(30		)	(101		)	—		71			285			475
Ending balance ALLR	$	2,661		$	1,090		$	97		$	877		$	—	$	13		$	439		$	5,177

At June 30,2013
Loans:
Ending balance	$	243,363		$	84,145		$	16,053		$	94,254		$	4,305	$	13,435		$	—		$	455,555
Ending balance ALLR	(2,661		)	(1,090		)	(97		)	(877		)	—		(13		)	(439		)	(5,177		)
Net loans	$	240,702		$	83,055		$	15,956		$	93,377		$	4,305	$	13,422		$	(439	)	$	450,378

Ending balance ALLR:
Individually evaluated	$	1,396		$	643		$	8		$	148		$	—	$	13		$	—		$	2,208
Collectively evaluated	1,265			447			89			729			—		—			439			2,969
Total	$	2,661		$	1,090		$	97		$	877		$	—	$	13		$	439		$	5,177

Ending balance Loans:
Individually evaluated	$	14,499		$	6,668		$	917		$	640		$	—	$	22		$	—		$	22,746
Collectively evaluated	228,864			77,477			15,136			93,614			4,305		13,413			—			432,809
Total	$	243,363		$	84,145		$	16,053		$	94,254		$	4,305	$	13,435		$	—		$	455,555

Impaired loans, by definition, are individually evaluated.

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MACKINAC FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

5. LOANS (Continued)

As part of the management of the loan portfolio, risk ratings are assigned to all commercial loans. Through the loan review process, ratings are modified as believed to be appropriate to reflect changes in the credit. Our ability to manage credit risk depends in large part on our ability to properly identify and manage problem loans.

To do so, we operate a credit risk rating system under which our credit management personnel assign a credit risk rating to each loan at the time of origination and review loans on a regular basis to determine each loan’s credit risk rating on a scale of 1 through 8, with higher scores indicating higher risk. The credit risk rating structure used is shown below.

In the context of the credit risk rating structure, the term Classified is defined as a problem loan which may or may not be in a nonaccrual status, dependent upon current payment status and collectability.

Strong (1)

Borrower is not vulnerable to sudden economic or technological changes. They have “strong” balance sheets and are within an industry that is very typical for our markets or type of lending culture. Borrowers also have “strong” financial and cash flow performance and excellent collateral (low loan to value or readily available to liquidate collateral) in conjunction with an impeccable repayment history.

Good (2)

Borrower shows limited vulnerability to sudden economic change. These borrowers have “above average” financial and cash flow performance and a very good repayment history. The balance sheet of the company is also very good as compared to peer and the company is in an industry that is familiar to our markets or our type of lending. The collateral securing the deal is also very good in terms of its type, loan to value, etc.

Average (3)

Borrower is typically a well-seasoned business, however may be susceptible to unfavorable changes in the economy, and could be somewhat affected by seasonal factors. The borrowers within this category exhibit financial and cash flow performance that appear “average” to “slightly above average” when compared to peer standards and they show an adequate payment history. Collateral securing this type of credit is good, exhibiting above average loan to values, etc.

Acceptable/Acceptable Watch (4)

A borrower within this category exhibits financial and cash flow performance that appear adequate and satisfactory when compared to peer standards and they show a satisfactory payment history. The collateral securing the request is within supervisory limits and overall is acceptable. Borrowers rated acceptable could also be newer businesses that are typically susceptible to unfavorable changes in the economy, and more than likely could be affected by seasonal factors.

Special Mention (5)

The borrower may have potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the institution’s credit position at some future date. Special mention assets are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification. Examples of this type of credit include a start-up company fully based on projections, a documentation issue that needs to be corrected or a general market condition that the borrower is working through to get corrected.

Substandard (6)

Substandard loans are classified assets exhibiting a number of well-defined weaknesses that jeopardize normal repayment. The assets are no longer adequately protected due to declining net worth, lack of earning capacity, or insufficient collateral offering the distinct possibility of the loss of a portion of the loan principal. Loans classified as substandard clearly represent troubled and deteriorating credit situations requiring constant supervision.

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MACKINAC FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

5. LOANS (Continued)

Doubtful (7)

Loans in this category exhibit the same, if not more pronounced weaknesses used to describe the substandard credit. Loans are frozen with collection improbable. Such loans are not yet rated as Charge-off because certain actions may yet occur which would salvage the loan.

Charge-off/Loss (8)

Loans in this category are largely uncollectible and should be charged against the loan loss reserve immediately.

General Reserves:

For loans with a credit risk rating of 5 or better and any loans with a risk rating of 6 or 7 with no specific reserve, reserves are established based on the type of loan collateral, if any, and the assigned credit risk rating. Determination of the allowance is inherently subjective as it requires significant estimates, including the amounts and timing of expected future cash flows on impaired loans, estimated losses on pools of homogenous loans based on historical loss experience, and consideration of current environmental factors and economic trends, all of which may be susceptible to significant change.

Using a historical average loss by loan type as a base, each loan graded as higher risk is assigned a specific percentage. Within the commercial loan portfolio, the historical loss rates are used for specific industries such as hospitality, gaming, petroleum, and forestry. The residential real estate and consumer loan portfolios are assigned a loss percentage as a homogenous group. If, however, on an individual loan the projected loss based on collateral value and payment histories are in excess of the computed allowance, the allocation is increased for the higher anticipated loss. These computations provide the basis for the allowance for loan losses as recorded by the Corporation.

Commercial construction loans in the amount of $3.153 million, $2.951 million and $3.394 million for the periods ended June 30, 2014, December 31, 2013 and June 30, 2013, respectively did not receive a specific risk rating. These amounts represent loans made for land development and unimproved land purchases. Below is a breakdown of loans by risk category as of June 30, 2014 (dollars in thousands):

							(4)
	(1)		(2)		(3)		Acceptable/		(5)		(6)		(7)		Rating
	Excellent		Good		Average		Acceptable Watch		Sp. Mention		Substandard		Doubtful		Unassigned		Total

Commercial real estate	$	15	$	25,065	$	121,108	$	126,593	$	—	$	1,719	$	—	$	—	$	274,500
Commercial, financial and agricultural	2,107		4,418		31,875		46,320		—		4,795		—		—		89,515
Commercial construction	—		460		2,919		3,616		—		402		—		3,153		10,550
One to four family residential real estate	—		2,329		1,303		4,344		—		—		—		97,892		105,868
Consumer construction	—		—		—		—		—		—		—		7,464		7,464
Consumer	—		—		20		39		—		—		—		14,984		15,043

Total loans	$	2,122	$	32,272	$	157,225	$	180,912	$	—	$	6,916	$	—	$	123,493	$	502,940

Below is a breakdown of loans by risk category as of December 31, 2013 (dollars in thousands):

							(4)
	(1)		(2)		(3)		Acceptable/		(5)		(6)		(7)		Rating
	Excellent		Good		Average		Acceptable Watch		Sp. Mention		Substandard		Doubtful		Unassigned		Total

Commercial real estate	$	1,502	$	23,310	$	116,702	$	125,010	$	—	$	2,285	$	—	$	—	$	268,809
Commercial, financial and agricultural	3,741		4,348		27,455		39,070		—		5,041		—		—		79,655
Commercial construction	30		479		2,702		4,340		—		402		—		2,951		10,904
One-to-four family residential real estate	251		3,074		1,275		4,482		—		710		—		93,976		103,768
Consumer construction	—		—		—		—		—		—		—		6,895		6,895
Consumer	10		—		37		43		—		30		—		13,681		13,801

Total loans	$	5,534	$	31,211	$	148,171	$	172,945	$	—	$	8,468	$	—	$	117,503	$	483,832

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MACKINAC FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

5. LOANS (Continued)

Below is a breakdown of loans by risk category as of June 30, 2013 (dollars in thousands):

							(4)
	(1)		(2)		(3)		Acceptable/		(5)		(6)		(7)		Rating
	Excellent		Good		Average		Acceptable Watch		Sp. Mention		Substandard		Doubtful		Unassigned		Total

Commercial real estate	$	2,294	$	22,319	$	86,404	$	111,180	$	16,446	$	4,531	$	189	$	—	$	243,363
Commercial, financial and agricultural	4,997		5,253		21,780		46,214		4,176		1,725		—		—		84,145
Commercial construction	—		723		5,119		5,660		755		402		—		3,394		16,053
One to four family residential real estate	—		1,954		2,465		4,565		—		—		—		85,270		94,254
Consumer construction	—		—		—		—		—		—		—		4,305		4,305
Consumer	—		109		36		470		—		—		—		12,820		13,435

Total loans	$	7,291	$	30,358	$	115,804	$	168,089	$	21,377	$	6,658	$	189	$	105,789	$	455,555

Impaired Loans

Nonperforming loans are those which are contractually past due 90 days or more as to interest or principal payments, on nonaccrual status, or loans, the terms of which have been renegotiated to provide a reduction or deferral on interest or principal. There was no interest income recorded during impairment for the three and six months ended June 30, 2014. Interest income that would have been recognized during these periods was $.029 million and $.053 million, respectively. For the three and six months ended June 30, 2013, the amounts that would have been recognized were $.059 million and $.117 million, respectively.

The accrual of interest on loans is discontinued when, in management’s opinion, the borrower may be unable to meet payment obligations as they become due, as well as when required by regulatory provisions. When interest accrual is discontinued, all unpaid accrued interest is reversed. Interest income is subsequently recognized only to the extent cash payments are received in excess of principal due. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

Loans are considered impaired when, based on current information and events, it is probable the Corporation will be unable to collect all amounts due in accordance with the original contractual terms of the loan agreement, including scheduled principal and interest payments. Impairment is evaluated in total for smaller-balance loans of a similar nature and on an individual loans basis for other loans. If a loan is impaired, a specific valuation allowance is allocated, if necessary, so that the loan is reported net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Interest payments on impaired loans are typically applied to principal unless collectability of the principal amount is reasonably assured, in which case interest is recognized on a cash basis. Impaired loans, or portions thereof, are charged off when deemed uncollectible.

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MACKINAC FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

5. LOANS (Continued)

The following is a summary of impaired loans and their effect on interest income (dollars in thousands):

											Three Months Ended				Six Months Ended
					QTD		YTD				Interest Income		Interest Income		Interest Income		Interest Income
	Nonaccrual		Accrual		Average		Average		Related		Recognized		on		Recognized		on
June 30, 2014	Basis		Basis		Investment		Investment		Valuation Reserve		During Impairment		Accrual Basis		During Impairment		Accrual Basis

*With no valuation reserve:*
Commercial real estate	$	278	$	—	$	279	$	304	$	—	$	—	$	4	$	—	$	8
Commercial, financial and agricultural	82		—		97		140		—		—		2		—		4
Commercial construction	—		—		—		—		—		—		—		—		—
One to four family residential real estate	37		—		38		97		—		—		—		—		3
Consumer construction	—		—		—		—		—		—		—		—		—
Consumer	—		—		3		6		—		—		—		—		—

*With a valuation reserve:*
Commercial real estate	$	176	$	—	$	176	$	176	$	104	$	—	$	3	$	—	$	7
Commercial, financial and agricultural	1,726		—		1,157		918		1,110		—		13		—		20
Commercial construction	—		—		—		—		—		—		—		—		—
One to four family residential real estate	346		—		279		299		100		—		7		—		11
Consumer construction	—		—		—		—		—		—		—		—		—
Consumer	7		—		7		8		1		—		—		—		—

*Total:*
Commercial real estate	$	454	$	—	$	455	$	480	$	104	$	—	$	7	$	—	$	15
Commercial, financial and agricultural	1,808		—		1,254		1,058		1,110		—		15		—		24
Commercial construction	—		—		—		—		—		—		—		—		—
One to four family residential real estate	383		—		317		396		100		—		7		—		14
Consumer construction	—		—		—		—		—		—		—		—		—
Consumer	7		—		10		14		1		—		—		—		—
Total	$	2,652	$	—	$	2,036	$	1,948	$	1,315	$	—	$	29	$	—	$	53

Table of Contents

MACKINAC FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

									Interest Income		Interest Income
For the Year Ended:	Nonaccrual		Accrual		Average		Related		Recognized		on
December 31, 2013	Basis		Basis		Investment		Valuation Reserve		During Impairment		Accrual Basis

With no valuation reserve:
Commercial real estate	$	513	$	—	$	3,045	$	—	$	—	$	153
Commercial, financial and agricultural	59		—		505		—		—		13
Commercial construction	—		—		626		—		—		3
One to four family residential real estate	361		—		625		—		—		16
Consumer construction	—		—		—		—		—		—
Consumer	—		—		2		—		—		—

With a valuation reserve:
Commercial real estate	$	59	$	—	$	71	$	14	$	—	$	5
Commercial, financial and agricultural	752		—		834		265		—		18
Commercial construction	—		—		—		—		—		—
One to four family residential real estate	250		—		261		78		—		20
Consumer construction	—		—		—		—		—		—
Consumer	30		—		30		13		—		—

Total:
Commercial real estate	$	572	$	—	$	3,116	$	14	$	—	$	158
Commercial, financial and agricultural	811		—		1,339		265		—		31
Commercial construction	—		—		626		—		—		3
One to four family residential real estate	611		—		886		78		—		36
Consumer construction	—		—		—		—		—		—
Consumer	30		—		32		13		—		—
Total	$	2,024	$	—	$	5,999	$	370	$	—	$	228

5. LOANS (Continued)

											Three Months Ended				Six Months Ended
					QTD		YTD				Interest Income		Interest Income		Interest Income		Interest Income
	Nonaccrual		Accrual		Average		Average		Related		Recognized		on		Recognized		on
June 30, 2013	Basis		Basis		Investment		Investment		Valuation Reserve		During Impairment		Accrual Basis		During Impairment		Accrual Basis

With no valuation reserve:
Commercial real estate	$	728	$	—	$	733	$	797	$	—	$	—	$	14	$	—	$	26
Commercial, financial and agricultural	176		—		206		248		—		—		3		—		6
Commercial construction	—		—		—		275		—		—		—		—		3
One to four family residential real estate	94		—		133		165		—		—		3		—		5
Consumer construction	—		—		—		—		—		—		—		—		—
Consumer	9		—		2		1		—		—		—		—		—

With a valuation reserve:
Commercial real estate	$	2,329	$	—	$	2,308	$	2,298	$	1,240	$	—	$	30	$	—	$	60
Commercial, financial and agricultural	341		—		267		199		106		—		4		—		6
Commercial construction	—		—		—		—		—		—		—		—		—
One to four family residential real estate	306		—		303		289		126		—		5		—		11
Consumer construction	—		—		—		—		—		—		—		—		—
Consumer	—		—		—		—		—		—		—		—		—

Total:
Commercial real estate	$	3,057	$	—	$	3,041	$	3,095	$	1,240	$	—	$	44	$	—	$	86
Commercial, financial and agricultural	517		—		473		447		106		—		7		—		12
Commercial construction	—		—		—		275		—		—		—		—		3
One to four family residential real estate	400		—		436		454		126		—		8		—		16
Consumer construction	—		—		—		—		—		—		—		—		—
Consumer	9		—		2		1		—		—		—		—		—
Total	$	3,983	$	—	$	3,952	$	4,272	$	1,472	$	—	$	59	$	—	$	117

A summary of past due loans at June 30, 2014, December 31, 2013 and June 30, 2013 is as follows (dollars in thousands):

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MACKINAC FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

	June 30,						December 31,						June 30,
	2014						2013						2013
	30-89 days		90+ days				30-89 days		90+ days				30-89 days		90+ days
	Past Due		Past Due/				Past Due		Past Due/				Past Due		Past Due/
	(accruing)		Nonaccrual		Total		(accruing)		Nonaccrual		Total		(accruing)		Nonaccrual		Total

Commercial real estate	$	602	$	454	$	1,056	$	—	$	572	$	572	$	146	$	3,057	$	3,203
Commercial, financial and agricultural	5		1,808		1,813		4		811		815		92		517		609
Commercial construction	—		—		—		20		—		20		—		—		—
One to four family residential real estate	141		383		524		201		611		812		100		400		500
Consumer construction	—		—		—		—		—		—		—		—		—
Consumer	57		7		64		14		30		44		18		9		27

Total past due loans	$	805	$	2,652	$	3,457	$	239	$	2,024	$	2,263	$	356	$	3,983	$	4,339

5. LOANS (Continued)

A roll-forward of nonperforming loan activity for the three months ended June 30, 2014 (dollars in thousands):

	For the Three Months Ended June 30, 2014
				Commercial,					One to four
	Commercial			Financial and			Commercial		family residential			Consumer
NONACCRUAL	Real Estate			Agricultural			Construction		real estate			Construction		Consumer			Total

Beginning balance	$	455		$	730		$	—	$	299		$	—	$	7		$	1,491

Principal payments	(3		)	(63		)	—		(14		)	—		—			(80		)
Charge-offs	—			—			—		—			—		(6		)	(6		)
Advances	—			—			—		—			—		—			—
Class transfers	—			—			—		—			—		—			—
Transfers to OREO	—			—			—		—			—		—			—
Transfers to accruing	—			—			—		—			—		—			—
Transfers from accruing	—			1,139			—		89			—		6			1,234
Other	2			2			—		9			—		—			13

Ending balance	$	454		$	1,808		$	—	$	383		$	—	$	7		$	2,652

A roll-forward of nonperforming loan activity for the three months ended June 30, 2013 (dollars in thousands):

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MACKINAC FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

	For the Three Months Ended June 30, 2013
				Commercial,					One to four
	Commercial			Financial and			Commercial		family residential			Consumer
NONACCRUAL	Real Estate			Agricultural			Construction		real estate			Construction		Consumer			Total

Beginning balance	$	2,963		$	424		$	—	$	446		$	—	$	—		$	3,833

Principal payments	(31		)	(66		)	—		(16		)	—		—			(113		)
Charge-offs	—			—			—		(6		)	—		(4		)	(10		)
Advances	—			—			—		—			—		—			—
Class transfers	—			—			—		—			—		—			—
Transfers to OREO	—			—			—		(38		)	—		—			(38		)
Transfers to accruing	—			—			—		—			—		—			—
Transfers from accruing	126			179			—		14			—		13			332
Other	(1		)	(20		)	—		—			—		—			(21		)

Ending balance	$	3,057		$	517		$	—	$	400		$	—	$	9		$	3,983

A roll-forward of nonperforming loan activity for the first six months ended June 30, 2014 (dollars in thousands):

	For the Six Months Ended June 30, 2014
				Commercial,					One to four
	Commercial			Financial and			Commercial		family residential			Consumer
NONACCRUAL	Real Estate			Agricultural			Construction		real estate			Construction		Consumer			Total

Beginning balance	$	572		$	811		$	—	$	611		$	—	$	30		$	2,024

Principal payments	(102		)	(81		)	—		(22		)	—		(4		)	(209		)
Charge-offs	—			(53		)	—		(3		)	—		(25		)	(81		)
Advances	—			—			—		—			—		—			—
Class transfers	—			—			—		—			—		—			—
Transfers to OREO	(26		)	—			—		(256		)	—		—			(282		)
Transfers to accruing	—			(10		)	—		(127		)	—		—			(137		)
Transfers from accruing	—			1,139			—		171			—		6			1,316
Other	10			2			—		9			—		—			21

Ending balance	$	454		$	1,808		$	—	$	383		$	—	$	7		$	2,652

5. LOANS (Continued)

A roll-forward of nonperforming loan activity for the first six months ended June 30, 2013 (dollars in thousands):

	For the Six Months Ended June 30, 2013
				Commercial,						One to four
	Commercial			Financial and			Commercial			family residential			Consumer
NONACCRUAL	Real Estate			Agricultural			Construction			real estate			Construction		Consumer			Total

Beginning balance	$	3,071		$	436		$	675		$	505		$	—	$	—		$	4,687

Principal payments	(148		)	(68		)	(100		)	(65		)	—		—			(381		)
Charge-offs	(329		)	(72		)	—			(13		)	—		(4		)	(418		)
Advances	—			—			—			—			—		—			—
Class transfers	—			—			—			—			—		—			—
Transfers to OREO	—			—			(580		)	(107		)	—		—			(687		)
Transfers to accruing	—			—			—			—			—		—			—
Transfers from accruing	443			241			—			76			—		13			773
Other	20			(20		)	5			4			—		—			9

Ending balance	$	3,057		$	517		$	—		$	400		$	—	$	9		$	3,983

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

A roll-forward of nonperforming loan activity during the year ended December 31, 2013 (dollars in thousands):

				Commercial,						One to four
	Commercial			Financial and			Commercial			family residential			Consumer
NONACCRUAL	Real Estate			Agricultural			Construction			real estate			Construction		Consumer			Total

Beginning balance	$	3,071		$	436		$	675		$	505		$	—	$	—		$	4,687

Principal payments	(1,478		)	(319		)	(100		)	(88		)	—		(2		)	(1,987		)
Charge-offs	(1,304		)	(616		)	—			(141		)	—		(4		)	(2,065		)
Advances	—			—			—			—			—		—			—
Class transfers	—			—			—			—			—		—			—
Transfers to OREO	(208		)	(37		)	(580		)	(107		)	—		—			(932		)
Transfers to accruing	—			—			—			—			—		—			—
Transfers from accruing	443			1,346			—			434			—		36			2,259
Other	48			1			5			8			—		—			62

Ending balance	$	572		$	811		$	—		$	611		$	—	$	30		$	2,024

Troubled Debt Restructuring

Troubled debt restructurings (“TDR”) are determined on a loan-by-loan basis. Generally restructurings are related to interest rate reductions, loan term extensions and short term payment forbearance as means to maximize collectability of troubled credits. If a portion of the TDR loan is uncollectible (including forgiveness of principal), the uncollectible amount will be charged off against the allowance at the time of the restructuring. In general, a borrower must make at least six consecutive timely payments before the Corporation would consider a return of a restructured loan to accruing status in accordance with FDIC guidelines regarding restoration of credits to accrual status.

The Corporation has, in accordance with generally accepted accounting principles and per recently enacted accounting standard updates, evaluated all loan modifications to determine the fair value impact of the underlying asset. The carrying amount of the loan is compared to the expected payments to be received, discounted at the loan’s original rate, or for collateral dependent loans, to the fair value of the collateral.

5. LOANS (Continued)

A summary of troubled debt restructurings for the periods indicated is as follows (dollars in thousands):

	June 30,			December 31,			June 30,
	2014			2013			2013
	Number of	Recorded		Number of	Recorded		Number of	Recorded
	Modifications	Investment		Modifications	Investment		Modifications	Investment

Commercial real estate	—	$	—	—	$	—	—	$	—
Commercial, financial and agricultural	—	—		1	528		—	—
Commercial construction	—	—		—	—		—	—
One to four family residential real estate	1	89		—	—		—	—
Consumer construction	—	—		—	—		—	—
Consumer	—	—		—	—		—	—

Total troubled debt restructurings	1	$	89	1	$	528	—	$	—

A roll-forward of troubled debt restructuring during the three months ended June 30, 2014 (dollars in thousands):

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

				Commercial,				One to four			Consumer and
	Commercial			Financial and		Commercial		family residential			Consumer
ACCRUING	Real Estate			Agricultural		Construction		real estate			Construction		Total

Beginning balance	$	1,009		$	1,186	$	858	$	187		$	—	$	3,240

Principal payments	(2		)	—		—		—			—		(2		)
Charge-offs	—			—		—		—			—		—
Advances	—			—		—		—			—		—
New restructured	—			—		—		—			—		—
Transferred out of TDR	—			—		—		—			—		—
Transfers to nonaccrual	—			—		—		(89		)	—		(89		)

Ending Balance	$	1,007		$	1,186	$	858	$	98		$	—	$	3,149

NONACCRUAL

Beginning balance	$	—		$	508	$	—	$	—		$	—	$	508

Principal payments	—			—		—		—			—		—
Charge-offs	—			—		—		—			—		—
Advances	—			—		—		—			—		—
New restructured	—			—		—		—			—		—
Transfers to foreclosed properties	—			—		—		—			—		—
Transfers from accruing	—			—		—		89			—		89

Ending Balance	$	—		$	508	$	—	$	89		$	—	$	597

TOTALS

Beginning balance	$	1,009		$	1,694	$	858	$	187		$	—	$	3,748

Principal payments	(2		)	—		—		—			—		(2		)
Charge-offs	—			—		—		—			—		—
Advances	—			—		—		—			—		—
New restructured	—			—		—		—			—		—
Transfers out of TDRs	—			—		—		—			—		—
Tansfers to nonaccrual	—			—		—		(89		)	—		(89		)
Transfers to foreclosed properties	—			—		—		—			—		—
Transfers from accruing	—			—		—		89			—		89

Ending Balance	$	1,007		$	1,694	$	858	$	187		$	—	$	3,746

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

5. LOANS (Continued)

A roll-forward of troubled debt restructuring during the three months ended June 30, 2013 (dollars in thousands):

				Commercial,				One to four		Consumer and
	Commercial			Financial and		Commercial		family residential		Consumer
ACCRUING	Real Estate			Agricultural		Construction		real estate		Construction		Total

Beginning balance	$	3,588		$	2,174	$	858	$	100	$	—	$	6,720

Principal payments	(25		)	—		—		—		—		(25		)
Charge-offs	—			—		—		—		—		—
Advances	—			—		—		—		—		—
New restructured	—			—		—		—		—		—
Transferred out of TDRs	—			—		—		—		—		—
Transfers to nonaccrual	—			—		—		—		—		—

Ending Balance	$	3,563		$	2,174	$	858	$	100	$	—	$	6,695

NONACCRUAL

Beginning balance	$	2,169		$	—	$	—	$	106	$	—	$	2,275

Principal payments	—			—		—		—		—		—
Charge-offs	—			—		—		—		—		—
Advances	—			—		—		—		—		—
New restructured	—			—		—		—		—		—
Transfers to foreclosed properties	—			—		—		—		—		—
Transfers from accruing	—			—		—		—		—		—

Ending Balance	$	2,169		$	—	$	—	$	106	$	—	$	2,275

TOTALS

Beginning balance	$	5,757		$	2,174	$	858	$	206	$	—	$	8,995

Principal payments	(25		)	—		—		—		—		(25		)
Charge-offs	—			—		—		—		—		—
Advances	—			—		—		—		—		—
New restructured	—			—		—		—		—		—
Transfers out of TDRs	—			—		—		—		—		—
Tansfers to nonaccrual	—			—		—		—		—		—
Transfers to foreclosed properties	—			—		—		—		—		—
Transfers from accruing	—			—		—		—		—		—

Ending Balance	$	5,732		$	2,174	$	858	$	206	$	—	$	8,970

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

5. LOANS (Continued)

A roll-forward of troubled debt restructuring during the six months ended June 30, 2014 (dollars in thousands):

				Commercial,					One to four			Consumer and
	Commercial			Financial and			Commercial		family residential			Consumer
ACCRUING	Real Estate			Agricultural			Construction		real estate			Construction		Total

Beginning balance	$	3,520		$	1,186		$	858	$	99		$	—	$	5,663

Principal payments	(2,513		)	—			—		(3		)	—		(2,516		)
Charge-offs	—													—
Advances	—													—
New restructured	—													—
Transferred out of TDRs	—													—
Transfers from accruing	—			—			—		91			—		91
Transfers to nonaccruing	—			—			—		(89		)	—		(89		)

Ending Balance	$	1,007		$	1,186		$	858	$	98		$	—	$	3,149

NONACCRUAL

Beginning balance	$	—		$	523		$	—	$	91		$	—	$	614

Principal payments	—			(15		)	—		—			—		(15		)
Charge-offs	—			—			—		—			—		—
Advances	—			—			—		—			—		—
New restructured	—			—			—		—			—		—
Transfers to accruing	—			—			—		(91		)	—		(91		)
Transfers from accruing	—			—			—		89			—		89

Ending Balance	$	—		$	508		$	—	$	89		$	—	$	597

TOTALS

Beginning balance	$	3,520		$	1,709		$	858	$	190		$	—	$	6,277

Principal payments	(2,513		)	(15		)	—		(3		)	—		(2,531		)
Charge-offs	—			—			—		—			—		—
Advances	—			—			—		—			—		—
New restructured	—			—			—		—			—		—
Transfers out of TDR	—			—			—		—			—		—
Transfers to nonaccrual	—			—			—		(89		)	—		(89		)
Transfers to accruing	—			—			—		89			—		89
Transfer from accruing	—			—			—		—			—		—

Ending Balance	$	1,007		$	1,694		$	858	$	187		$	—	$	3,746

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

5. LOANS (Continued)

A roll-forward of troubled debt restructuring during the six months ended June 30, 2013 (dollars in thousands):

				Commercial,				One to four			Consumer and
	Commercial			Financial and		Commercial		family residential			Consumer
ACCRUING	Real Estate			Agricultural		Construction		real estate			Construction		Total

Beginning balance	$	3,611		$	1,221	$	858	$	102		$	—	$	5,792

Principal payments	(48		)	—		—		(2		)	—		(50		)
Charge-offs	—			—		—		—			—		—
Advances	—			—		—		—			—		—
New restructured	—			953		—		—			—		953
Transferred out of TDRs	—			—		—		—			—		—
Transfers to nonaccrual	—			—		—		—			—		—

Ending Balance	$	3,563		$	2,174	$	858	$	100		$	—	$	6,695

NONACCRUAL

Beginning balance	$	2,162		$	—	$	—	$	102		$	—	$	2,264

Principal payments	—			—		—		—			—		—
Charge-offs	—			—		—		—			—		—
Advances	—			—		—		—			—		—
New restructured	7			—		—		4			—		11
Transfers to foreclosed properties	—			—		—		—			—		—
Transfers from accruing	—			—		—		—			—		—

Ending Balance	$	2,169		$	—	$	—	$	106		$	—	$	2,275

TOTALS

Beginning balance	$	5,773		$	1,221	$	858	$	204		$	—	$	8,056

Principal payments	(48		)	—		—		(2		)	—		(50		)
Charge-offs	—			—		—		—			—		—
Advances	—			—		—		—			—		—
New restructured	7			953		—		4			—		964
Transfers out of TDRs	—			—		—		—			—		—
Transfers to nonaccrual	—			—		—		—			—		—
Transfers to foreclosed properties	—			—		—		—			—		—
Transfers from accruing	—			—		—		—			—		—

Ending Balance	$	5,732		$	2,174	$	858	$	206		$	—	$	8,970

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

5. LOANS (Continued)

A roll-forward of troubled debt restructuring during the year ended December 31, 2013 (dollars in thousands):

				Commercial,					One to four			Consumer and
	Commercial			Financial and			Commercial		family residential			Consumer
ACCRUING	Real Estate			Agricultural			Construction		real estate			Construction		Total

Beginning balance	$	3,611		$	1,221		$	858	$	102		$	—	$	5,792

Principal payments	(91		)	(460		)			(3		)	—		(554		)
Charge-offs	—			—					—			—		—
Advances	—			—					—			—		—
New restructured	—			953					—			—		953
Transferred out of TDR	—			—					—			—		—
Transfers to nonaccrual	—			(528		)			—			—		(528		)

Ending Balance	$	3,520		$	1,186		$	858	$	99		$	—	$	5,663

NONACCRUAL

Beginning balance	$	2,162		$	—		$	—	$	102		$	—	$	2,264
							—
Principal payments	(1,376		)	(5		)	—		(15		)	—		(1,396		)
Charge-offs	(793		)	—			—		—			—		(793		)
Advances	—			—			—		—			—		—
New restructured	7			528			—		4			—		539
Transfers to foreclosed properties	—			—			—		—			—		—
Transfers from accruing	—			—			—		—			—		—

Ending Balance	$	—		$	523		$	—	$	91		$	—	$	614

TOTALS

Beginning balance	$	5,773		$	1,221		$	858	$	204		$	—	$	8,056

Principal payments	(1,467		)	(465		)	—		(18		)	—		(1,950		)
Charge-offs	(793		)	—			—		—			—		(793		)
Advances	—			—			—		—			—		—
New restructured	7			1,481			—		4			—		1,492
Transfers out of TDRs	—			—			—		—			—		—
Tansfers to nonaccrual	—			(528		)	—		—			—		(528		)
Transfers to foreclosed properties	—			—			—		—			—		—
Transfers from accruing	—			—			—		—			—		—

Ending Balance	$	3,520		$	1,709		$	858	$	190		$	—	$	6,277

Insider Loans

The Bank, in the ordinary course of business, grants loans to the Corporation’s executive officers and directors, including their families and firms in which they are principal owners. Activity in such loans is summarized below (dollars in thousands):

	June 30,			December 31,			June 30,
	2014			2013			2013

Loans outstanding, beginning of period	$	9,043		$	11,297		$	11,297
New loans	—			496			496
Net activity on revolving lines of credit	1,178			(266		)	(25		)
Principal payments	(1,523		)	(2,484		)	(1,298		)

Loans outstanding, end of period	$	8,698		$	9,043		$	10,470

There were no loans to related parties classified substandard as of June 30, 2014, December 31, 2013 or June 30, 2013. In addition to the outstanding balances above, there were unfunded commitments of $.575 million to related parties at June 30, 2014.

6. MORTGAGE SERVICING RIGHTS

Mortgage servicing rights (“MSRs”) are recorded when loans are sold in the secondary market with servicing retained. As of June 30, 2014, the Corporation had obligations to service approximately $138 million of residential

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

first mortgage loans. The valuation is based upon the net present value of the projected revenues over the expected life of the loans being serviced, as reduced by estimated internal costs to service these loans. The fair value of the capitalized servicing rights approximates the carrying value. The key economic assumptions used in determining the fair value of the mortgage servicing rights include an annual constant prepayment speed of 10.13% and a discount rate of 8.16% for June 30, 2014.

The following summarizes mortgage servicing rights capitalized and amortized, along with the aggregate activity in related valuation allowances (dollars in thousands):

	Six Months Ended			Year Ended			Six Months Ended
	June 30,			December 31,			June 30,
	2014			2013			2013

Balance at beginning of period	$	1,129		$	638		$	638
Additions from loans sold with servicing retained	75			675			225
Amortization	(143		)	(184		)	(80		)

Balance at end of period	$	1,061		$	1,129		$	783

7. BORROWINGS

Borrowings consist of the following at June 30, 2014, December 31, 2013 and June 30, 2013 (dollars in thousands):

	June 30,		December 31,		June 30,
	2014		2013		2013

Federal Home Loan Bank fixed rate advances at June 30, 2014 with a weighted average rate of 1.82% maturing in 2014, 2016 and 2018	$	35,000	$	35,000	$	35,000

Correspondent bank line of credit - holding company	500		2,000		—

Bank line of credit - wholly-owned asset based lending subsidiary	2,835		—		—

Correspondent bank term note, current floor rate of 4%, maturing March 22, 2017	2,900		—		—

USDA Rural Development, fixed-rate note payable, maturing August 24, 2024, interest payable at 1%	852		852		925

	$	42,087	$	37,852	$	35,925

The Federal Home Loan Bank borrowings are collateralized at June 30, 2014 by the following: a collateral agreement on the Corporation’s one to four family residential real estate loans with a book value of approximately $44.140 million; mortgage related and municipal securities with an amortized cost and estimated fair value of $4.378 million and $4.530 million, respectively; and Federal Home Loan Bank stock owned by the Bank totaling $3.060 million. Prepayment of the advances is subject to the provisions and conditions of the credit policy of the Federal Home Loan Bank of Indianapolis in effect as of June 30, 2014.

The USDA Rural Development borrowing is collateralized by loans totaling $.125 million originated and held by the Corporation’s wholly owned subsidiary, First Rural Relending, and an assignment of a demand deposit account in the amount of $.798 million, and guaranteed by the Corporation.

The Corporation currently has two banking borrowing relationships. The first relationship consists of a line of credit and a term note. The line of credit bears interest at 90-day LIBOR plus 2.75%, with a floor rate of 4.00% and has an initial term that expires on March 22, 2015. The term note bears the same interest and matures on March 22, 2017. The second borrowing relationship consists of a $10 million revolving line of credit, which can be increased to $25 million upon request, used to support asset based lending activities at a wholly-owned subsidiary that currently bears interest at 90-day LIBOR plus 2.75% and has an initial term that expires on September 10, 2016.

8. STOCK COMPENSATION PLANS

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

may be awarded incentive stock options, non-statutory stock options, shares of restricted stock units (“RSUs”), or stock appreciation rights. The aggregate number of shares of the Company’s common stock issuable under the plan is 575,000, which included 392,152 option shares outstanding at that time.

The Corporation, in August 2012 and March 2014, granted Restricted Stock Units (“RSUs”) to members of the Board of Directors and Management. In August 2012, 148,500 RSUs were granted at a market value of $7.91 and will vest equally over a four year term. In exchange for the grant of the August 2012 RSUs, various previously issued stock option awards were surrendered. In March 2014, 52,774 RSUs were granted at a market value of $12.95, also vesting equally over a four year term. The RSUs were awarded at no cost to the employee. Compensation cost to be recognized over the four-year vesting periods, is $1.175 million and $.683 million, respectively. On August 31, 2013, the Corporation issued 37,125 shares of its common stock for vested RSUs. As of June 30, 2014, RSUs totaling 164,149 were unvested and unrecognized compensation expense was $1.270 million.

A summary of stock option transactions for the six months ended June 30, 2014 and 2013, and the year ended December 31, 2013, is as follows:

	June 30,		December 31,			June 30,
	2014		2013			2013

Outstanding shares at beginning of year	237,152		242,152			242,152
Granted during the period	—		—			—
Exercised during the period	—		—			—
Expired / forfeited during the period	—		(5,000		)	—

Outstanding shares at end of period	237,152		237,152			242,152

Exercisable shares at end of period	124,861		124,861			126,361

Weighted average exercise price per share at end of period	$	9.80	$	9.80		$	9.88

Shares available for grant at end of period	—		—			—

There were no options granted in the first six months of 2014 and 2013.

Following is a summary of the options outstanding and exercisable at June 30, 2014:

					Weighted Average
Exercise		Number			Remaining
Price		Outstanding	Exercisable	Unvested Options	Contractual Life-Years

$	9.75	217,152	120,861	96,291	.48
$	10.65	10,000	2,000	8,000	1.04
$	12.00	10,000	2,000	8,000	2.46
		237,152	124,861	112,291	.59

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MACKINAC FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

8. STOCK COMPENSATION PLANS (Continued)

Options issued since the Corporation’s recapitalization in December of 2004 call for 20% immediate vesting upon issue and subsequent vesting to occur over a two to five year period, based upon the market value appreciation of the underlying Corporation’s stock. Compensation related to these options was expensed based upon the vesting period without consideration given to market value appreciation. There are no future compensation expenses related to existing option programs.

9. INCOME TAXES

A valuation allowance is provided against deferred tax assets when it is more likely than not that some or all of the deferred tax asset will not be realized. The Corporation, as of June 30, 2014 had a net operating loss and tax credit carryforwards for tax purposes of approximately $17.2 million, and $2.4 million, respectively. The net operating loss carryforwards expire twenty years from the date they originated. These carryforwards, if not utilized, will begin to expire in the year 2023. A portion of the NOL, approximately $10.3 million, and all of the credit carryforwards are subject to the limitations for utilization as set forth in Section 382 of the Internal Revenue Code. The annual limitation is $1.400 million for the NOL and the equivalent value of tax credits, which is approximately $.476 million. These limitations for use were established in conjunction with the recapitalization of the Corporation in December 2004.

The Corporation has reported deferred tax assets of $9.097 million at June 30, 2014, which is net of a valuation allowance of $.760 million. Management evaluated the deferred tax valuation allowance as of June 30, 2014 and determined that no adjustment to the valuation was warranted. The remaining valuation allowance pertains to the existing tax credit carryovers, which will only be utilized after all net operating loss carryforwards. Since a portion of these tax credits may expire before that occurs, a valuation allowance for these has been established. The Corporation will continue to evaluate the future benefits from these carryforwards in order to determine if any adjustment to the deferred tax asset is warranted.

10. FAIR VALUE MEASUREMENTS

Fair value estimates, methods, and assumptions are set forth below for the Corporation’s financial instruments:

Cash, cash equivalents, and interest-bearing deposits - The carrying values approximate the fair values for these assets.

Securities - Fair values are based on quoted market prices where available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities and other inputs such as interest rates and yield curves that are observable at commonly quoted intervals.

Federal Home Loan Bank stock — Federal Home Loan Bank stock is carried at cost, which is its redeemable value and approximates its fair value, since the market for this stock is limited.

Loans - Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type such as commercial, residential mortgage, and other consumer. The fair value of loans is calculated by discounting scheduled cash flows using discount rates reflecting the credit and interest rate risk inherent in the loan.

The methodology in determining fair value of nonaccrual loans is to average them into the blended interest rate at 0% interest. This has the effect of decreasing the carrying amount below the risk-free rate amount and, therefore, discounts the estimated fair value.

Impaired loans are measured at the estimated fair value of the expected future cash flows at the loan’s effective interest rate or the fair value of the collateral for loans which are collateral dependent. Therefore, the carrying values of impaired loans approximate the estimated fair values for these assets.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

10. FAIR VALUE MEASUREMENTS (Continued)

Deposits - The fair value of deposits with no stated maturity, such as noninterest-bearing demand deposits and savings, is equal to the amount payable on demand at the reporting date. The fair value of time deposits is based on the discounted value of contractual cash flows applying interest rates currently being offered on similar time deposits.

Borrowings - Rates currently available for debt with similar terms and remaining maturities are used to estimate the fair value of existing debt. The fair value of borrowed funds due on demand is the amount payable at the reporting date.

Accrued interest - The carrying amount of accrued interest approximates fair value.

Off-balance-sheet instruments - The fair value of commitments is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements, the current interest rates, and the present creditworthiness of the counterparties. Since the differences in the current fees and those reflected to the off-balance-sheet instruments at year-end are immaterial, no amounts for fair value are presented.

The following table presents information for financial instruments at June 30, 2014, December 31, 2013 and June 30, 2013 (dollars in thousands):

		June 30, 2014				December 31, 2013				June 30, 2013
	Level in Fair	Carrying		Estimated		Carrying		Estimated		Carrying		Estimated
	Value Hierarchy	Amount		Fair Value		Amount		Fair Value		Amount		Fair Value

Financial assets:
Cash and cash equivalents	Level 1	$	20,746	$	20,746	$	18,219	$	18,219	$	26,219	$	26,219
Interest-bearing deposits	Level 2	235		235		10		10		10		10
Securities available for sale	Level 2	47,374		47,374		44,388		44,388		47,307		47,307
Federal Home Loan Bank stock	Level 2	3,060		3,060		3,060		3,060		3,060		3,060
Net loans	Level 2	497,843		499,609		479,171		479,538		450,378		444,638
Accrued interest receivable	Level 3	1,485		1,485		1,351		1,351		1,636		1,636

Total financial assets		$	570,743	$	572,509	$	546,199	$	546,566	$	528,610	$	522,870

Financial liabilities:
Deposits	Level 2	$	484,016	$	485,230	$	466,299	$	465,431	$	447,907	$	446,438
Borrowings	Level 2	42,087		42,699		37,852		37,487		35,925		35,621
Accrued interest payable	Level 3	186		186		182		182		229		229

Total financial liabilties		$	526,289	$	528,115	$	504,333	$	503,100	$	484,061	$	482,288

Limitations - Fair value estimates are made at a specific point in time based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Corporation’s entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Corporation’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. Fair value estimates are based on existing on-and off-balance-sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. Significant assets and liabilities that are not considered financial assets or liabilities include premises and equipment, other assets, and other liabilities. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates.

The following is information about the Corporation’s assets and liabilities measured at fair value on a recurring basis at June 30, 2014, and the valuation techniques used by the Corporation to determine those fair values.

Level 1: In general, fair values determined by Level 1 inputs use quoted prices in active markets for identical assets or liabilities that the Corporation has the ability to access.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

10. FAIR VALUE MEASUREMENTS (Continued)

Level 2: Fair values determined by Level 2 inputs use other inputs that are observable, either directly or indirectly. These Level 2 inputs include quoted prices for similar assets and liabilities in active markets, and other inputs such as interest rates and yield curves that are observable at commonly quoted intervals.

Level 3: Level 3 inputs are unobservable inputs, including inputs available in situations where there is little, if any, market activity for the related asset or liability.

The fair value of all investment securities at June 30, 2014 and June 30, 2013 were based on level 2 inputs. There are no other assets or liabilities measured on a recurring basis at fair value. For additional information regarding investment securities, please refer to “Note 4 Investment Securities.”

The Corporation had no Level 3 assets or liabilities on a recurring basis as of June 30, 2014, December 31, 2013 or June 30, 2013.

In instances where inputs used to measure fair value fall into different levels in the above fair value hierarchy, fair value measurements in their entirety are categorized based on the lowest level input that is significant to the valuation. The Corporation’s assessment of the significance of particular inputs to these fair value measurements requires judgment and considers factors specific to each asset or liability.

The Corporation also has assets that under certain conditions are subject to measurement at fair value on a non-recurring basis. These assets include loans and other real estate owned. The Corporation has estimated the fair values of these assets using Level 3 inputs, specifically discounted cash flow projections.

Assets Measured at Fair Value on a Nonrecurring Basis at June 30, 2014

Quoted Prices

Significant

in Active Markets

Other Observable

Unobservable

Total Losses for

Balance at

for Identical Assets

Inputs

Three Months Ended

Six Months Ended

(dollars in thousands)

June 30, 2014

(Level 1)

(Level 2)

(Level 3)

June 30, 2014

Assets

Impaired loans

2,652

—

2,652

430

Other real estate owned

1,947

—

1,947

444

Assets Measured at Fair Value on a Nonrecurring Basis at December 31, 2013

			Quoted Prices		Significant		Significant
			in Active Markets		Other Observable		Unobservable		Total Losses for
	Balance at		for Identical Assets		Inputs		Inputs		Year Ended
(dollars in thousands)	December 31, 2013		(Level 1)		(Level 2)		(Level 3)		December 31, 2013
Assets

Impaired loans	$	2,024	$	—	$	—	$	2,024	$	2,075
Other real estate owned	1,884		—		—		1,884		265

									$	2,340

Assets Measured at Fair Value on a Nonrecurring Basis at June 30, 2013

			Quoted Prices		Significant		Significant
			in Active Markets		Other Observable		Unobservable		Total Losses for		Total Losses for
	Balance at		for Identical Assets		Inputs		Inputs		Three Months Ended		Six Months Ended
(dollars in thousands)	June 30, 2013		(Level 1)		(Level 2)		(Level 3)		June 30, 2013		June 30, 2013
Assets

Impaired loans	$	3,983	$	—	$	—	$	3,983	$	10	$	418
Other real estate owned	2,481		—		—		2,481		87		89
									$	97	$	507

The Corporation had no investments subject to fair value measurement on a nonrecurring basis.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

10. FAIR VALUE MEASUREMENTS (Continued)

Impaired loans categorized as Level 3 assets consist of non-homogeneous loans that are considered impaired. The Corporation estimates the fair value of the loans based on the present value of expected future cash flows using management’s best estimate of key assumptions. These assumptions include future payment ability, timing of payment streams, and estimated realizable values of available collateral (typically based on outside appraisals).

11. SHAREHOLDERS’ EQUITY

In August 2012 the Corporation consummated the previously announced $7.000 million rights offering and the investment by Steinhardt Capital Investors, LLLP (“SCI”) by issuing 2,140,123 shares of common stock for net proceeds of $11.506 million. Also, in August 2012, the Corporation exited the TARP Capital Purchase Program (“CPP”) when the Corporation’s 11,000 Series A Preferred Shares, issued in April, 2009 to the U.S. Treasury, were publically offered and sold. The Corporation repurchased the 379,310 of Common Stock Warrants issued to the U.S. Treasury under the CPP in December, 2012 for $1.3 million. During 2013, the Corporation redeemed all of the outstanding Series A Preferred Shares.

The Corporation currently has a share repurchase program. The program is conducted under authorizations from time to time by the Board of Directors. The Corporation repurchased 55,594 shares in 2013 and 13,700 shares in the first quarter of 2014. The share repurchases were conducted under Board authorizations made and publically announced of $600,000 on February 27, 2013 and an additional $600,000 on December 17, 2013. Neither of these authorizations has an expiration date.

12. COMMITMENTS, CONTINGENCIES AND CREDIT RISK

Financial Instruments With Off-Balance-Sheet Risk

The Corporation is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the consolidated balance sheets.

The Corporation’s exposure to credit loss, in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit, is represented by the contractual amount of those instruments. The Corporation uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. These commitments are as follows (dollars in thousands):

	June 30,		December 31,		June 30,
	2014		2013		2013
Commitments to extend credit:
Variable rate	$	54,048	$	36,039	$	37,462
Fixed rate	18,604		15,070		19,873
Standby letters of credit - Variable rate	5,742		5,077		3,805
Credit card commitments - Fixed rate	3,234		3,152		3,113

	$	81,628	$	59,338	$	64,253

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Corporation evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Corporation upon extension of credit, is based on management’s credit evaluation of the party. Collateral held varies, but may include accounts receivable, inventory, property, plant and equipment, and income-producing commercial properties.

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MACKINAC FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

12. COMMITMENTS, CONTINGENCIES AND CREDIT RISK (Continued)

Standby letters of credit are conditional commitments issued by the Corporation to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The commitments are structured to allow for 100% collateralization on all standby letters of credit.

Credit card commitments are commitments on credit cards issued by the Corporation’s subsidiary and serviced by other companies. These commitments are unsecured.

Legal Proceedings and Contingencies

In the normal course of business, the Corporation is involved in various legal proceedings. For expanded discussion on the Corporation’s legal proceedings, see Part II, Item 1, “Legal Proceedings” in this report.

Concentration of Credit Risk

The Bank grants commercial, residential, agricultural, and consumer loans throughout Michigan. The Bank’s most prominent concentration in the loan portfolio relates to commercial real estate loans to operators of nonresidential buildings. This concentration at June 30, 2014 represents $103.598 million, or 27.66%, compared to $95.510 million, or 27.80%, of the commercial loan portfolio on June 30, 2013. The remainder of the commercial loan portfolio is diversified in such categories as hospitality and tourism, real estate agents and managers, new car dealers, gaming, petroleum, forestry, agriculture and construction. Due to the diversity of the Bank’s locations, the ability of debtors of residential and consumer loans to honor their obligations is not tied to any particular economic sector.

13. SUBSEQUENT EVENT

On July 18, 2014, the Corporation announced the signing of a definitive agreement to acquire Peninsula Financial Corporation (“Peninsula”) for $13.285 million. The purchase price of Peninsula contemplates a special dividend to Peninsula shareholders prior to the consummation that would reduce the acquired equity to $10.5 million. Peninsula is headquartered in Marquette County, Michigan and is the parent of Peninsula Bank with June 30 assets of approximately $132 million and six banking offices. The consummation of this transaction is expected to occur late in the third or early in the fourth quarter of 2014.

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Forward Looking Statements/Risk Factors

FORWARD LOOKING STATEMENTS

This report contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. The Corporation intends such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995 and is including this statement for purposes of these safe harbor provisions. Forward-looking statements which are based on certain assumptions and describe future plans, strategies, or expectations of the Corporation, are generally identifiable by use of the words “believe”, “expect”, “intend”, “anticipate”, “estimate”, “project”, or similar expressions. The Corporation’s ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors that could cause actual results to differ from the results in forward-looking statements include, but are not limited to:

RISK FACTORS

Risks Related to our Lending and Credit Activities

· Our business may be adversely affected by conditions in the financial markets and economic conditions generally, as our borrowers’ ability to repay loans and the value of the collateral securing our loans decline.

· Weakness in the markets for residential or commercial real estate, including the secondary residential mortgage loan markets, could reduce our net income and profitability.

· Our allowance for loan losses may be insufficient.

Continuing deterioration in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans, and other factors, both within and outside of our control, may require an increase in our allowance for loan losses.

Risks Related to Our Operations

· We are subject to interest rate risk.

Our earnings and cash flows are largely dependent upon our net interest income, which is the difference between interest income on interest-earning assets such as loans and securities and interest expense paid on interest-bearing liabilities such as deposits and borrowed funds. There are many factors which influence interest rates that are beyond our control, including but not limited to general economic conditions and governmental policy, in particular, the policies of the FRB.

· Changes in our accounting policies or in accounting standards could materially affect how we report our financial results and condition.

· Our controls and procedures may fail or be circumvented.

· Impairment of deferred income tax assets could require charges to earnings, which could result in an adverse impact on our results of operations.

In assessing the realizability of deferred income tax assets, management considers whether it is more likely than not that some allowance requires management to evaluate all available evidence, both negative and positive. Positive evidence necessary to overcome the negative evidence includes whether future taxable income in sufficient amounts and character within the carry back and carry forward periods is available under the tax law, including the use of tax planning strategies. When negative evidence (e.g. cumulative losses in recent years, history of operating loss or tax credit carry forwards expiring unused) exists, more positive evidence than negative evidence will be necessary. At June 30, 2014, net deferred tax assets are approximately $9.1 million. If an additional valuation allowance becomes necessary with respect to such balance, it could have a material adverse effect on our business, results of operations and financial condition.

· Our information systems may experience an interruption or breach in security.

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Risks Related to Legal and Regulatory Compliance

· We operate in a highly regulated environment, which could increase our cost structure or have other negative impacts on our operations.

· The full impact of the recently enacted Dodd-Frank Act is currently unknown given that many of the details and substance of the new laws will be implemented through agency rulemaking.

Among the many requirements if the Dodd-Frank Act for new banking regulations is a requirement for new capital regulations to be adopted within 15 months. These regulations must be at least as stringent as, and may call for higher levels of capital than, current regulations.

Strategic Risks

· Maintaining or increasing our market share may depend on lowering prices and market acceptance of new products and services.

· Future growth or operating results may require us to raise additional capital but that capital may not be available.

Reputation Risks

· Unauthorized disclosure of sensitive or confidential client or customer information, whether through a breach of our computer system or otherwise, could severely harm our business.

Liquidity Risks

· We could experience an unexpected inability to obtain needed liquidity.

The ability of a financial institution to meet its current financial obligations is a function of its balance sheet structure, its ability to liquidate assets and its access to alternative sources of funds. We seek to ensure our funding needs are met by maintaining an appropriate level of liquidity through asset/liability management.

Risks Related to an Investment in Our Common Stock

· Limited trading activity for shares of our common stock may contribute to price volatility.

· Our securities are not an insured deposit.

· You may not receive dividends on your investment in common stock.

Our ability to pay dividends is dependent upon our receipt of dividends from the Bank, which is subject to regulatory restrictions. Such restrictions, which govern state-chartered banks, generally limit the payment of dividends on bank stock to the bank’s undivided profits after all payments of all necessary expenses, provided that the bank’s surplus equals or exceeds its capital.

These risks and uncertainties should be considered in evaluating forward-looking statements. Further information concerning the Corporation and its business, including additional factors that could materially affect the Corporation’s financial results, is included in the Corporation’s filings with the Securities and Exchange Commission. All forward-looking statements contained in this report are based upon information presently available and the Corporation assumes no obligation to update any forward-looking statements.

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ITEM 2 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion will cover results of operations, asset quality, financial position, liquidity, interest rate sensitivity, and capital resources for the periods indicated. The information included in this discussion is intended to assist readers in their analysis of, and should be read in conjunction with, the consolidated financial statements and related notes and other supplemental information presented elsewhere in this report. This discussion should be read in conjunction with the consolidated financial statements and footnotes contained in the Corporation’s Annual Report and Form 10-K for the year-ended December 31, 2013. Throughout this discussion, the term “Bank” refers to mBank, the principal banking subsidiary of the Corporation.

FINANCIAL OVERVIEW

The Corporation recorded a second quarter 2014 income of $.806 million or $.15 per share compared to net income available to common shareholders of $1.197 million, or $.22 per share for the second quarter of 2013. Operating results for the first six months of 2014 totaled $1.466 million or $.27 per share, compared to $1.873 million, or $.34 per share, for the same period in 2013.

Weighted average shares totaled 5,529,290 shares for the six month period in 2014 and 5,527,690 shares in the 2014 second quarter compared to 5,557,842 shares for the six month period in 2013 and 5,556,133 shares in the 2013 second quarter of 2013.

The net interest margin for the second quarter of 2014 increased to $5.659 million, or 4.18%, compared to $5.269 million, or 4.16% in the second quarter of 2013. The six month margin in 2014 was $11.252 million, or 4.21% compared to $10.425 million, or 4.17%.

Total assets of the Corporation at June 30, 2014 were $595.869 million, up by $42.368 million, or 7.65% from the $553.501 million in total assets reported at June 30, 2013 and up by $23.069 million, or 4.03%, from total assets of $572.800 million at year-end 2013. The loan portfolio increased $19.108 million, or 3.95%, from December 31, 2013 balances of $483.832 million. Deposits totaled $484.016 million at June 30, 2014, an increase of $17.717 million from the $466.299 million at December 31, 2013.

FINANCIAL CONDITION

Cash and Cash Equivalents

Cash and cash equivalents increased $2.527 million during the first half of 2014. See further discussion of the change in cash and cash equivalents in the Liquidity section.

Investment Securities

Securities available for sale increased $2.986 million from December 31, 2013 to June 30, 2014, with the balance on June 30, 2014, totaling $47.374 million. Investment securities are utilized in an effort to manage interest rate risk and liquidity. As of June 30, 2014, investment securities with an estimated fair value of $4.605 million were pledged.

Loans

Through the first half of 2014, loan balances increased by $19.108 million, or 3.95%, from December 31, 2013 balances of $483.832 million. During the first half of 2014, the Bank had total loan production of $86 million, which included $11 million of secondary market loan production. This loan production, however, was offset by loan principal runoff, paydowns and amortization, and also SBA/USDA loan sales of $4.724 million, and nonperforming loans transferred to other real estate owned (“OREO”) amounting to $.282 million.

Management continues to actively manage the loan portfolio, seeking to identify and resolve problem assets at an early stage. Management believes a properly positioned loan portfolio provides the most attractive earning asset yield available to the Corporation and, with a diligent loan approval process and exception reporting, management can effectively manage the risk in the loan portfolio. Management intends to continue loan growth within its markets for mortgage, consumer, and commercial loan products while concentrating on loan quality, industry concentration issues, and competitive pricing.

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Following is a summary of the loan portfolio at June 30, 2014, December 31, 2013 and June 30, 2013 (dollars in thousands):

	June 30,		Percent of		December 31,		Percent of		June 30,		Percent of
	2014		Total		2013		Total		2013		Total
Commercial real estate	$	274,500	54.58	%	$	268,809	55.56	%	$	243,363	53.42	%
Commercial, financial, and agricultural	89,515		17.80		79,655		16.46		84,145		18.47
One to four family residential real estate	105,868		21.05		103,768		21.45		94,254		20.69
Construction:
Consumer	7,464		1.48		6,895		1.43		4,305		.95
Commercial	10,550		2.10		10,904		2.25		16,053		3.52
Consumer	15,043		2.99		13,801		2.85		13,435		2.95
Total loans	$	502,940	100.00	%	$	483,832	100.00	%	$	455,555	100.00	%

Following is a table showing the significant industry types in the commercial loan portfolio as of June 30, 2014, December 31, 2013 and June 30, 2013 (dollars in thousands):

	June 30, 2014						December 31, 2013						June 30, 2013
	Outstanding		Percent of		Percent of		Outstanding		Percent of		Percent of		Outstanding		Percent of		Percent of
	Balance		Loans		Capital		Balance		Loans		Capital		Balance		Loans		Capital

Real estate - operators of nonres bldgs	$	103,598	27.66	%	155.84	%	$	100,333	27.92	%	153.77	%	$	95,510	27.80	%	143.58	%
Hospitality and tourism	42,111		11.24		63.35		45,360		12.62		106.90		42,833		12.47		64.39
Lessors of residential buildings	14,912		3.98		22.43		14,191		3.95		21.75		13,377		3.89		20.11
Gasoline and convenience stores	11,881		3.17		17.87		11,534		3.21		17.68		11,038		3.21		16.59
Real estate agents and managers	11,388		3.04		17.13		10,922		3.04		16.74		9,472		2.76		14.24
Commercial construction	10,550		2.82		15.87		10,904		3.03		16.46		16,053		4.67		24.13
Other	180,125		48.09		270.96		166,124		46.23		41.90		155,278		45.20		233.43

Total Commercial Loans	$	374,565	100.00	%			$	359,368	100.00	%			$	343,561	100.00	%

Management recognizes the additional risk presented by the concentration in certain segments of the portfolio. On a historical basis, the Corporation’s highest concentration of credit risk was the hospitality and tourism industry. Management does not consider the current loan concentrations in hospitality and tourism to be problematic, and has no intention of further reducing loans to this industry segment. Management does not believe that its current portfolio composition has increased exposure related to any specific industry concentration as of June 30, 2014. The current concentration of real estate related loans represents a broad customer base composed of a high percentage of owner occupied developments.

Our residential real estate portfolio predominantly includes one to four family adjustable rate mortgages that have repricing terms generally from one to three years, construction loans to individuals and bridge financing loans for qualifying customers. As of June 30, 2014, our residential loan portfolio totaled $105.868 million, or 21.05% of our total outstanding loans.

The Corporation has also extended credit to governmental units, including Native American organizations. Tax-exempt loans and leases increased from $1.526 million at the end of December 31, 2013 to $2.113 million at June 30, 2014.

Due to the seasonal nature of many of the Corporation’s commercial loan customers, loan payment terms provide flexibility by structuring payments to coincide with the customer’s business cycle. The lending staff evaluates the collectability of the past due loans based on documented collateral values and payment history. The Corporation discontinues the accrual of interest on loans when, in the opinion of management, there is an indication that the borrower may be unable to meet the payments as they become due. Upon such discontinuance, all unpaid accrued interest is reversed. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured.

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Credit Quality

Management analyzes the allowance for loan losses in detail on a monthly basis to determine whether the losses inherent in the portfolio are properly reserved for. Net recoveries for the six months ended June 30, 2014 amounted to $62,000, compared to net charge-offs of $.516 million, or .23% of average loans outstanding, for the same period in 2013. The current reserve balance is representative of the relevant risk inherent within the Corporation’s loan portfolio. Additions or reductions to the reserve in future periods will be dependent upon a combination of future loan growth, nonperforming loan balances and charge-off activity.

The table below shows period end balances of nonperforming assets (dollars in thousands):

	June 30,			December 31,			June 30,
	2014			2013			2013
Nonperforming Assets:
Nonaccrual Loans	$	2,055		$	1,410		$	3,983
Loans past due 90 days or more	—			—			—
Restructured loans	597			614			—
Total nonperforming loans	2,652			2,024			3,983
Other real estate owned	1,947			1,884			2,481
Total nonperforming assets	$	4,599		$	3,908		$	6,464
Nonperforming loans as a % of loans	.53		%	.42		%	.87		%
Nonperforming assets as a % of assets	.77		%	.68		%	1.17		%
Reserve for Loan Losses:
At period end	$	5,097		$	4,661		$	5,177
As a % of loans	1.01		%	.96		%	1.14		%
As a % of nonperforming loans	192.19		%	230.29		%	129.98		%
As a % of nonaccrual loans	248.03		%	330.57		%	129.98		%
Texas ratio*	6.43		%	5.59		%	9.02		%

*calculated by taking total nonperforming assets divided by total equity plus reserve for loan losses

Nonperforming assets at $4.599 million were reduced by $1.865 million from one year ago and increased $.691 million from the $3.908 million at 2013 year end. The current low level of nonperforming assets is also representative of the overall quality of the Corporation’s loan portfolio.

The following ratios provide additional information relative to the Corporation’s credit quality:

	At Period End				At Period End
	June 30, 2014		December 31, 2013		June 30, 2013
			.
Total loans, at period end	$	502,940	$	483,832	$	455,555
Average loans for the year	$	489,656	$	462,500	$	453,023

	For the Period Ended						For the Period Ended
	Six Months Ended			Twelve Months Ended			Six Months Ended
	June 30, 2014			December 31, 2013			June 30, 2013

Net charge-offs (recoveries) during the period	$	(62	)	$	2,232		$	516
Net charge-offs to average loans	N/M		%	.48		%	.23		%
Net charge-offs to beginning allowance balance	N/M		%	42.78		%	9.89		%

Management continues to address market issues impacting its loan customer base. In conjunction with the Corporation’s senior lending staff and the bank regulatory examinations, management reviews the Corporation’s loans, related collateral evaluations, and the overall lending process. The Corporation also utilizes an outside loan review consultant to perform a review of the loan portfolio. Historically, this independent review has provided findings similar to management as to the overall adequacy of the loan loss reserve and has substantiated the Corporation’s loan rating system. In 2014, the Corporation will again utilize a consultant for loan review.

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As of June 30, 2014, the allowance for loan losses represented 1.01% of total loans. At June 30, 2014, the allowance included specific reserves in the amount of $1.438 million, as compared to $1.111 million at December 31, 2013 and $2.208 million at June 30, 2013. In management’s opinion, the allowance for loan losses is adequate to cover probable losses related to specifically identified loans, as well as probable losses inherent in the balance of the loan portfolio.

As part of the process of resolving problem credits, the Corporation may acquire ownership of collateral which secured such credits. The Corporation carries this collateral in other real estate on the balance sheet.

The following table represents the activity in other real estate for the periods indicated (dollars in thousands):

	Six Months Ended			Year Ended			Six Months Ended
	June 30 2014			December 31, 2013			June 30 2013

Balance at beginning of period	$	1,884		$	3,212		$	3,212
Other real estate transferred from loans due to foreclosure	282			932			687
Other real estate sold	(205		)	(1,996		)	(1,329		)
Writedowns on other real estate held for sale	(2		)	(231		)	(114		)
Gain (loss) on sale of other real estate held for sale	(12		)	(33		)	25

Balance at end of period	$	1,947		$	1,884		$	2,481

During the first half of 2014, the Corporation received real estate in lieu of loan payments of $.282 million. Other real estate is initially valued at the lower of cost or the fair value less selling costs. After the initial receipt, management periodically re-evaluates the recorded balances and any additional reductions in the fair value result in a write-down of other real estate.

Deposits

The Corporation had an increase in deposits in the first six months of 2014. Total deposits increased by $17.717 million, or 3.80%, in the first half of 2014. The increase in deposits for the first half of 2014 is composed of an increase in noncore deposits of $12.538 million and an increase in core deposits of $5.179 million. In recent years, the Corporation has strategically emphasized the growth of core deposits. This strategic initiative is supported with an individual incentive plan, along with the introduction of several new deposit products and competitive deposit pricing. The core deposit balances increased primarily in transactional account deposits, our lowest cost of funds. Most recently, we have experienced some declines in core deposits. A portion of these decreases can be attributed to individual customer deposit reductions due to various business related needs. In an effort to stem some runoff from core deposit CDs, management recently increased some offering rates on CD products.

Management continues to monitor existing deposit products in order to stay competitive as to both terms and pricing. It is the intent of management to be aggressive in its markets to grow core deposits with an emphasis placed on transactional deposits.

The following table represents detail of deposits at the end of the periods indicated (dollars in thousands):

	June 30,				December 31,				June 30,
	2014		% of Total		2013		% of Total		2013		% of Total

Noninterest bearing	$	73,732	15.23	%	$	72,936	15.64	%	$	64,736	14.45	%
NOW, money market, checking	148,242		30.63		149,123		31.98		146,203		32.64
Savings	15,658		3.24		13,039		2.80		12,229		2.73
Certificates of Deposit <$100,000	143,140		29.57		140,495		30.13		134,767		30.09
Total core deposits	380,772		78.67		375,593		80.55		357,935		79.91

Certificates of Deposit >$100,000	23,151		4.78		23,159		4.96		25,091		5.60
Brokered CDs	80,093		16.55		67,547		14.49		64,881		14.49
Total non-core deposits	103,244		21.33		90,706		19.45		89,972		20.09

Total deposits	$	484,016	100.00	%	$	466,299	100.00	%	$	447,907	100.00	%

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Borrowings

The Corporation also utilizes FHLB borrowings as a source of funding. At June 30, 2014, this source of funding totaled $35 million and the Corporation secured this funding by pledging loans and investments. The $35 million of FHLB borrowings has a weighted average maturity of 1.96 years and a weighted average rate of 1.79% at June 30, 2014. The Corporation also has a USDA Rural Development loan held by its wholly owned subsidiary, First Rural Relending that has an outstanding balance of $.852 million, with a fixed interest rate of 1% that matures in August 2024.

In addition to the above, the Corporation currently has two banking borrowing relationships. The first relationship consists of a line of credit and a term note. The line of credit bears interest at 90-day LIBOR plus 2.75%, with a floor rate of 4.00% and has an initial term that expires on March 22, 2015. The term note bears the same interest and matures on March 22, 2017. The second borrowing relationship consists of a $10 million revolving line of credit, which can be increased to $25 million upon request, used to support asset based lending activities at a wholly-owned subsidiary that currently bears interest at 90-day LIBOR plus 2.75% and has an initial term that expires on September 10, 2016.

Shareholders’ Equity

Total shareholders’ equity increased $1.228 million from December 31, 2013 to June 30, 2014. Contributing to the increase in shareholders’ equity was net income available to common shareholders of $1.466 million, a reduction for dividends on common stock of $.553 million, increases due to stock compensation of $.225 million, an increase in the market value of securities of $.233 million and a decrease due to the repurchase of common stock of $.143 million.

RESULTS OF OPERATIONS

Summary

The Corporation reported net income available to common shareholders of $1.466 million, or $.27 per share, in the first half of 2014, compared to $1.873 million or $.34 per share for the first half of 2013. The first half results include a provision for loan losses of $.374 million. Operating results for the same period in 2013 include a provision for loan losses of $.475 million.

Net Interest Income

Net interest income is the Corporation’s primary source of core earnings. Net interest income represents the difference between the average yield earned on interest earning assets and the average rate paid on interest bearing obligations. The net interest income is impacted by economic and competitive factors that influence rates, loan demand, and the availability of funding.

Net interest margin on a fully taxable equivalent basis amounted to $5.661 million, 4.18% of average earning assets, in the second quarter of 2014, compared to $5.287 million, and 4.17% of average earning assets, in the second quarter of 2013. In the first six months of 2014, net interest margin increased to $11.277 million, 4.22% of average earning assets, compared to $10.460 million, 4.19 % of average earning assets, for the same period in 2013.

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The following table presents the amount of interest income from average interest-earning assets and the yields earned on those assets, as well as the interest expense on average interest-bearing obligations and the rates paid on those obligations. All average balances are daily average balances.

	Three Months Ended
																		2014-2013
	Average Balances									Average Rates				Interest				Income/									Rate/
	June 30,						Increase/			June 30,				June 30,				Expense			Volume			Rate			Volume
(dollars in thousands)	2014			2013			(Decrease)			2014		2013		2014		2013		Variance			Variance			Variance			Variance

Loans (1,2,3)	$	492,922		$	456,937		$	35,985		5.18	%	5.32	%	$	6,370	$	6,056	$	314		$	477		$	(151	)	$	(12	)
Taxable securities	45,515			47,456			(1,941		)	2.15		2.04		244		241		3			(10		)	13			—
Nontaxable securities (2)	1,828			835			993			3.73		4.80		17		10		7			12			(2		)	(3		)
Federal funds sold	3			3			—			—		—		—		—		—			—			—			—
Other interest-earning assets	3,160			3,070			90			4.32		4.18		34		32		2			1			1			—
Total earning assets	543,428			508,301			35,127			4.92		5.00		6,665		6,339		326			480			(139		)	(15		)
Reserve for loan losses	(4,960		)	(5,180		)	220
Cash and due from banks	16,272			17,927			(1,655		)
Fixed Assets	9,883			10,635			(752		)
Other Real Estate	2,112			3,175			(1,063		)
Other assets	14,415			13,597			818
Total assets	$	581,150		$	548,455		$	32,695

NOW and money market deposits	$	96,397		$	116,362		$	(19,965	)	.22	%	.25	%	$	54	$	72	$	(18	)	$	(12	)	$	(7	)	$	1
Interest checking	47,288			36,761			10,527			.24		.32		28		29		(1		)	8			(7		)	(2		)
Savings deposits	15,151			13,085			2,066			.11		.09		4		3		1			—			—			1
CDs <$100,000	145,494			130,957			14,537			1.19		1.60		433		524		(91		)	58			(134		)	(15		)
CDs >$100,000	23,229			24,610			(1,381		)	1.26		1.66		73		102		(29		)	(6		)	(25		)	2
Brokered deposits	72,781			53,449			19,332			1.15		1.17		208		156		52			56			(3		)	(1		)
Borrowings	43,043			40,656			2,387			1.90		1.64		204		166		38			10			27			1
Total interest-bearing liabilities	443,383			415,880			27,503			.91		1.01		1,004		1,052		(48		)	114			(149		)	(13		)
Demand deposits	69,380			64,556			4,824
Other liabilities	2,834			536			2,298
Shareholders’ equity	65,553			67,483			(1,930		)
Total liabilities and shareholders’ equity	$	581,150		$	548,455		$	32,695
Rate spread										4.01	%	3.99	%
Net interest margin/revenue										4.18	%	4.17	%	$	5,661	$	5,287	$	374		$	366		$	10		$	(2	)

	Six Months Ended
																		2014-2013
	Average Balances									Average Rates				Interest				Income/									Rate/
	June 30,						Increase/			June 30,				June 30,				Expense			Volume			Rate			Volume
(dollars in thousands)	2014			2013			(Decrease)			2014		2013		2014		2013		Variance			Variance			Variance			Variance

Loans (1,2,3)	$	489,656		$	453,023		$	36,633		5.22	%	5.41	%	$	12,687	$	11,986	$	701		$	969		$	(248	)	$	(20	)
Taxable securities	44,392			47,082			(2,690		)	2.19		2.06		481		481		—			(27		)	29			(2		)
Nontaxable securities (2)	1,668			839			829			4.96		4.81		41		20		21			20			1			—
Federal funds sold	3			3			—			—		—		—		—		—			—			—			—
Other interest-earning assets	3,115			3,070			45			5.24		4.14		81		63		18			1			17			—
Total earning assets	538,834			504,017			34,817			4.97		5.02		13,290		12,550		740			963			(201		)	(22		)
Reserve for loan losses	(4,907		)	(5,153		)	246
Cash and due from banks	20,038			18,243			1,795
Fixed Assets	10,085			10,634			(549		)
Other Real Estate	2,085			3,234			(1,149		)
Other assets	14,799			13,912			887
Total assets	$	580,934		$	544,887		$	36,047

NOW and money market deposits	$	106,565		$	120,797		$	(14,232	)	.22	%	.25	%	$	114	$	150	$	(36	)	$	(18	)	$	(21	)	$	3
Interest checking	40,228			36,418			3,810			.22		.32		44		57		(13		)	6			(17		)	(2		)
Savings deposits	14,365			13,279			1,086			.10		.11		7		7		—			1			(1		)	—
CDs <$100,000	148,390			131,297			17,093			1.21		1.62		892		1,057		(165		)	138			(268		)	(35		)
CDs >$100,000	23,217			24,620			(1,403		)	1.33		1.66		153		203		(50		)	(12		)	(41		)	3
Brokered deposits	70,183			45,621			24,562			1.18		1.28		412		289		123			156			(21		)	(12		)
Borrowings	40,937			38,679			2,258			1.93		1.70		391		327		64			19			42			3
Total interest-bearing liabilities	443,885			410,711			33,174			0.91		1.03		2,013		2,090		(77		)	290			(327		)	(40		)
Demand deposits	68,875			62,475			6,400
Other liabilities	2,666			1,854			812
Shareholders’ equity	65,508			69,847			(4,339		)
Total liabilities and shareholders’ equity	$	580,934		$	544,887		$	36,047
Rate spread										4.06	%	3.99	%
Net interest margin/revenue										4.22	%	4.19	%	$	11,277	$	10,460	$	817		$	673		$	126		$	18

(1) For purposes of these computations, nonaccruing loans are included in the daily average loan amounts outstanding.

(2) The amount of interest income on loans and nontaxable securities has been adjusted to a tax euivalent basis, using a 34% tax rate

(3) Interest income on loans includes fees

In the past several years of a low interest rate environment, the Corporation repriced all of its brokered deposits along with the majority of its bank time deposits. This repricing of liabilities is the primary reason for the increased interest margin, on a fully taxable equivalent basis in recent reported periods.

During this relatively low interest environment, the Corporation has also repriced a significant portion of its loan portfolio. Management has been diligent when repricing maturing or new loans in establishing interest rate floors in order to maintain our improved interest rate spread. The Corporation is anticipating some margin pressure in future periods as we continue to see extremely competitive pricing on new and renewable loans.

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Provision for Loan Losses

The Corporation records a provision for loan losses when it believes it is necessary to adjust the allowance for loan losses to maintain an adequate level after considering factors such as loan charge-offs and recoveries, changes in identified levels of risk in the loan portfolio, changes in the mix of loans in the portfolio, loan growth, and other economic factors. During the first half of 2014, the Corporation determined through this analysis that a $.374 million provision for loan loss was required, compared to $.475 million in the first half of 2013. There were net recoveries of $62,000 in the first half of 2014, compared to net charge-offs of $.516 million for the same period in 2013.

Other Income

Other income, at $1.341 million in the first half of 2014, decreased $.668 million from the first half of 2013 level of $2.009 million. Other income decreased primarily as a result of a reduced level of fees and gains on the sale of loans from secondary market mortgage lending of $.336 million from prior year period.

Management continues to evaluate deposit products and services for ways to better serve its customer base and also enhance service fee income through a broad array of products that price services based on income contribution and cost attributes.

The following table details other income for the three and six months ended June 30, 2014 and 2013 (dollars in thousands):

	Three Months Ended									Six Months Ended
	June 30,									June 30,
					Increase/(Decrease)									Increase/(Decrease)
	2014		2013		Dollars			Percent		2014		2013		Dollars			Percent

Deposit service fees	$	192	$	175	$	17		9.71	%	$	349	$	337	$	12		3.56	%
Income from secondary market loans sold	139		279		(140		)	(50.18	)	242		578		(336		)	(58.13	)
SBA/USDA loan sale gains	166		554		(388		)	(70.04	)	548		663		(115		)	(17.35	)
Mortgage servicing income	89		182		(93		)	(51.10	)	102		285		(183		)	(64.21	)
Other noninterest income	64		61		3			4.92		100		146		(46		)	(31.51	)

Total other income	$	650	$	1,251	$	(601	)	(48.04	)%	$	1,341	$	2,009	$	(668	)	(33.25	)%

Other Expense

For the first half of 2014, the Corporation recorded other expense of $10.005 million compared to $8.834 million in 2013, an increase of $1.171 million. The largest increase from the first half of 2013 was in salaries and benefits, largely reflective of the compensation packages for the staff up of our asset based lending subsidiary formed in the third quarter of 2013. We also had increased occupancy costs between periods due primarily to our new Marquette branch office, which we moved into late in 2013. We incurred some additional legal costs as well in the first half of 2014 for the exploration of acquisitions.

The following table details other expense for the three and six months ended June 30, 2014 and 2013 (dollars in thousands):

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	Three Months Ended									Six Months Ended
	June 30,									June 30,
					Increase/(Decrease)									Increase/(Decrease)
	2014		2013		Dollars			Percentage		2014		2013		Dollars			Percentage
Salaries and employee benefits	$	2,523	$	2,375	$	148		6.23	%	$	5,064	$	4,681	$	383		8.18	%
Occupancy	546		363		183			50.41		1,084		745		339			45.50
Furniture and equipment	303		255		48			18.82		622		525		97			18.48
Data processing	288		268		20			7.46		574		533		41			7.69
Advertising	123		111		12			10.81		230		215		15			6.98
Professional service fees	276		320		(44		)	(13.75	)	607		545		62			11.38
Loan and deposit	83		45		38			84.44		162		118		44			37.29
Writedowns and losses on other real estate held for sale	14		87		(73		)	(83.91	)	14		89		(75		)	(84.27	)
FDIC insurance premiums	90		95		(5		)	(5.26	)	175		200		(25		)	(12.50	)
Telephone	82		63		19			30.16		164		145		19			13.10
Other	570		541		29			5.36		1,309		1,038		271			26.11
Total other expense	$	4,898	$	4,523	$	375		8.29	%	$	10,005	$	8,834	$	1,171		13.26	%

Federal Income Taxes

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LIQUIDITY

Liquidity is defined as the ability to generate cash at a reasonable cost to fulfill lending commitments and support asset growth, while satisfying the withdrawal demands of customers and make payments on existing borrowing commitments. The Bank’s principal sources of liquidity are core deposits and loan and investment payments and prepayments. Providing a secondary source of liquidity is the available for sale investment portfolio. As a final source of liquidity, the Bank can exercise existing credit arrangements.

Current balance sheet liquidity consists of $20.746 million in cash and due from balances, negligible fed funds sold, $42.769 million of unpledged investment securities. Although current liquidity is deemed adequate, management will increase on hand liquidity in the near term by issuing brokered CDs in order to fund anticipated loan growth.

During the first six months of 2014, the Corporation increased cash and cash equivalents by $2.527 million. As shown on the Corporation’s condensed consolidated statement of cash flows, liquidity was impacted by cash used in investing activities, with a net increase in loans of $19.354 million. Offsetting the net decrease used by investing activities was cash provided by financing activities, primarily a net increase in deposits of $17.717 million. The management of bank liquidity for funding of loans and deposit maturities and withdrawals includes monitoring projected loan fundings and scheduled prepayments and deposit maturities within a 30 day period, a 30- to 90- day period and from 90 days until the end of the year. This funding forecast model is completed weekly.

The Corporation’s primary source of liquidity on a stand-alone basis is dividends from the Bank. The Corporation also has a line of credit with a correspondent bank with current availability of $2.500 million. The Corporation’s current plan for dividends from the Bank are dependent upon the profitability of the Bank, growth of assets at the Bank and the level of capital needed to stay “well capitalized.”

Liquidity is managed by the Corporation through its Asset and Liability Committee (“ALCO”). The ALCO Committee meets monthly to discuss asset and liability management in order to address liquidity and funding needs to provide a process to seek the best alternatives for investments of assets, funding costs, and risk management. The liquidity position of the Bank is managed daily, thus enabling the Bank to adapt its position according to market fluctuations. Core deposits are important in maintaining a strong liquidity position as they represent a stable and relatively low cost source of funds. The Bank’s liquidity is best illustrated by the mix in the Bank’s core and noncore funding dependence ratio, which explains the degree of reliance on noncore liabilities to fund long-term assets.

Core deposits are herein defined as demand deposits, NOW (negotiable order withdrawals), money markets, savings and certificates of deposit under $100,000. Noncore funding consists of certificates of deposit greater than $100,000, brokered deposits, and FHLB and Farmers’ Home Administration borrowings. At June 30, 2014, the Bank’s core deposits in relation to total funding were 72.38% compared to 73.98% at June 30, 2013. These ratios indicated at June 30, 2014, that the Bank has increased its reliance on noncore deposits and borrowings to fund the Bank’s long-term assets, namely loans and investments. The bank believes that by maintaining adequate volumes of short-term investments and implementing competitive pricing strategies on deposits, it can ensure adequate liquidity to support future growth. The Bank also has correspondent lines of credit available to meet unanticipated short-term liquidity needs. As of June 30, 2014, the Bank had $28.375 million of unsecured lines available and additional funding sources available if secured. The bank believes that its liquidity position remains strong to meet both present and future financial obligations and commitments, events or uncertainties that have resulted or are reasonably likely to result in material changes with respect to the Bank’s liquidity.

From a long-term perspective, the Corporation’s strategy is to increase core deposits in the Corporation’s local markets. Management continually evaluates deposit products offered in order to remain competitive in its goal of increasing core deposits. The Corporation will and has the ability to augment local deposit growth efforts with wholesale CD funding.

CAPITAL AND REGULATORY

As a bank holding company, the Corporation is required to maintain certain levels of capital under government regulation. There are several measurements of regulatory capital and the Corporation is required to meet minimum requirements under each measurement. The federal banking regulators have also established capital classifications beyond the minimum requirements in order to risk-rate deposit insurance premiums and to provide trigger points for prompt corrective action in the event an institution becomes financially troubled. As of June 30, 2014, the Corporation and Bank were well capitalized. During the first six months of 2014, total capitalization increased by $1.228 million.

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The following table details sources of capital for the periods indicated (dollars in thousands):

	June 30,			December 31,			June 30,
	2014			2013			2013

Capital Structure
Shareholders’ equity	$	66,477		$	65,249		$	62,520
Preferred stock	—			—			4,000
Total shareholders’ equity	$	66,477		$	65,249		$	66,520
Total capitalization	$	66,477		$	65,249		$	66,520
Tangible capital	$	66,477		$	65,249		$	66,520

Intangible Assets
Core deposit premium	$	—		$	—		$	—
Other identifiable intangibles	1,061			1,129			830
Total intangibles	$	1,061		$	1,129		$	830

Regulatory capital
Tier 1 capital:
Shareholders’ equity	$	66,477		$	65,249		$	66,520
Net unrealized (gains) losses on available for sale securities	(449		)	(216		)	(430		)
Less: disallowed deferred tax asset	(5,500		)	(7,000		)	(6,500		)
Less: intangibles	(106		)	(113		)	(83		)
Total Tier 1 capital	$	60,422		$	57,920		$	59,507
Tier 2 Capital:
Allowable reserve for loan losses	$	5,097		$	4,661		$	5,177
Qualifying long-term debt	—			—			—
Total Tier 2 capital	5,097			4,661			5,177
Total capital	$	65,519		$	62,581		$	64,684
Risk-adjusted assets	$	508,874		$	489,407		$	467,090

Capital ratios:
Tier 1 Capital to average assets	10.50		%	10.31		%	11.01		%
Tier 1 Capital to risk weighted assets	11.87		%	11.83		%	12.74		%
Total Capital to risk weighted assets	12.88		%	12.79		%	13.85		%

Regulatory capital is not the same as shareholders’ equity reported in the accompanying condensed consolidated financial statements. Certain assets cannot be considered assets for regulatory purposes, such as acquisition intangibles and noncurrent deferred tax benefits.

Presented below is a summary of the capital position in comparison to generally applicable regulatory requirements:

	Shareholders’		Tangible		Tier 1		Tier 1		Total
	Equity to		Equity to		Capital to		Capital to		Capital to
	Quarter-end		Quarter-end		Average		Risk-Weighted		Risk-Weighted
	Assets		Assets		Assets		Assets		Assets

Regulatory minumum for capital adequacy purposes	N/A		N/A		4.00	%	4.00	%	8.00	%
Regulatory defined well capitalized guideline	N/A		N/A		5.00	%	6.00	%	10.00	%

The Corporation:
June 30, 2014	11.16	%	11.16	%	10.50	%	11.87	%	12.88	%
June 30, 2013	12.02	%	12.02	%	11.01	%	12.74	%	13.85	%

The Bank:
June 30, 2014	11.20	%	11.20	%	10.50	%	11.90	%	12.88	%
June 30, 2013	11.18	%	11.18	%	10.15	%	11.74	%	12.84	%

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

INTEREST RATE RISK

In general, the Corporation attempts to manage interest rate risk by investing in a variety of assets which afford it an opportunity to reprice assets and increase interest income at a rate equal to or greater than the interest expense associated with repricing liabilities.

Interest rate risk is the exposure of the Corporation to adverse movements in interest rates. The Corporation derives its income primarily from the excess of interest collected on its interest-earning assets over the interest paid on its interest-bearing obligations. The rates of interest the Corporation earns on its assets and owes on its obligations generally are established contractually for a period of time. Since market interest rates change over time, the Corporation is exposed to lower profitability if it cannot adapt to interest rate changes. Accepting interest rate risk can be an important source of profitability and shareholder value; however, excess levels of interest rate risk could pose a significant threat to the Corporation’s earnings and capital base. Accordingly, effective risk management that maintains interest rate risk at prudent levels is essential to the Corporation’s safety and soundness.

Loans are the most significant earning asset. Management offers commercial and real estate loans priced at interest rates which fluctuate with various indices such as the prime rate or rates paid on various government issued securities. In addition, the Corporation prices the majority of fixed rate loans so it has an opportunity to reprice the loan within 12 to 36 months.

The Corporation has established interest rate floors on approximately $143.787 million of its variable rate commercial loans. These interest rate floors will result in a “lag” on the repricing of these variable rate loans when and if interest rates increase in future periods. Approximately $98.781 million of the “floor rate” loan balances will reprice with a 100 basis point increase on the prime rate, with another $40.915 million repricing in the next 100 basis point prime rate increase.

The Corporation also has $47.374 million of securities providing for scheduled monthly principal and interest payments as well as unanticipated prepayments of principal. These cash flows are then reinvested into other earning assets at current market rates. The Corporation also has federal funds sold to correspondent banks as well as other interest-bearing deposits with correspondent banks. These funds are generally repriced on a daily basis.

The Corporation has $237.632 million of transactional accounts, of which $73.732 million consists of noninterest bearing demand deposit balances. Transaction account balances have increased significantly in the last year due in part to the Corporation’s focus on these low costs accounts by developing new attractive products and increased sales efforts to municipalities, schools and businesses. These transactional account balances provide additional repricing flexibility in changing interest rate environments since they have no scheduled maturities and interest rates can be reset at any time.

Other deposit products have a variety of terms ranging from deposits whose interest rates can change on a weekly basis to certificates of deposit with repricing terms of up to five years. Longer term deposits generally include penalty provisions for early withdrawal.

Beyond general efforts to shorten the loan pricing periods and extend deposit maturities, management can manage interest rate risk by the maturity periods of securities purchased, selling securities available for sale, and borrowing funds with targeted maturity periods, among other strategies. Also, the rate of interest rate changes can impact the actions taken since the rate environment affects borrowers and depositors differently.

Exposure to interest rate risk is reviewed on a regular basis. Interest rate risk is the potential of economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values. The objective is to measure the effect of interest rate changes on net interest income and to structure the composition of the balance sheet to minimize interest rate risk and at the same time maximize income. Management realizes certain risks are inherent and that the goal is to identify and minimize the risks. Tools used by management include maturity and repricing analysis and interest rate sensitivity analysis. The Bank has monthly asset/liability meetings with an outside consultant to review its current position and strategize about future opportunities on risks relative to pricing and positioning of assets and liabilities.

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The difference between repricing assets and liabilities for a specific period is referred to as the gap. An excess of repricable assets over liabilities is referred to as a positive gap. An excess of repricable liabilities over assets is referred to as a negative gap. The cumulative gap is the summation of the gap for all periods to the end of the period for which the cumulative gap is being measured.

Assets and liabilities scheduled to reprice are reported in the following time frames. Those instruments with a variable interest rate tied to an index and considered immediately repricable are reported in the 1- to 90-day time frame. The estimates of principal amortization and prepayments are assigned to the following time frames.

The following are the Corporation’s repricing opportunities at June 30, 2014 (dollars in thousands):

1-90

91 - 365

>1-5

Over 5

Days

Years

Total

Interest-earning assets:

Loans

221,607

101,993

178,085

1,255

502,940

Securities

3,306

3,080

28,131

12,857

47,374

Other (1)

237

—

3,060

3,297

Total interest-earning assets

225,150

105,073

206,216

17,172

553,611

Interest-bearing obligations:

NOW, money market, savings, interest checking

163,900

—

163,900

Time deposits

31,246

62,427

72,468

150

166,291

Brokered CDs

17,728

10,877

51,488

—

80,093

Borrowings

500

10,000

30,735

852

42,087

Total interest-bearing obligations

213,374

83,304

154,691

1,002

452,371

Gap

11,776

21,769

51,525

16,170

101,240

Cumulative gap

11,776

33,545

85,070

101,240

(1) Includes Federal Home Loan Bank Stock

The above analysis indicates that at June 30, 2014, the Corporation had a cumulative asset sensitivity gap position of $33.545 million within the one-year time frame. The Corporation’s cumulative asset sensitive gap suggests that if market interest rates were to increase in the next twelve months, the Corporation has the potential to earn more net interest income. Since more assets would reprice at higher rates than liabilities. Conversely, if market interest rates decrease in the next twelve months, the above gap position suggests the Corporation’s net interest income would decrease. A limitation of the traditional gap analysis is that it does not consider the timing or magnitude of non-contractual repricing or expected prepayments. In addition, the gap analysis treats savings, NOW, and money market accounts as repricing within 90 days, while experience suggests that these categories of deposits are actually comparatively resistant to rate sensitivity.

At December 31, 2013, the Corporation had a cumulative liability sensitivity gap position of $24.272 million within the one-year time frame.

The borrowings in the gap analysis include $35.000 million of FHLB advances that have a weighted average maturity of 1.96 years and a weighted average rate of 1.79%.

The Corporation’s primary market risk exposure is interest rate risk and, to a lesser extent, liquidity risk and foreign exchange risk. The Corporation has no market risk sensitive instruments held for trading purposes. The Corporation has limited agricultural-related loan assets and therefore has minimal significant exposure to changes in commodity prices. Any impact that changes in foreign exchange rates and commodity prices would have on interest rates are assumed to be insignificant.

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Evaluating the exposure to changes in interest rates includes assessing both the adequacy of the process used to control interest rate risk and the quantitative level of exposure. The Corporation’s interest rate risk management process seeks to ensure that appropriate policies, procedures, management information systems, and internal controls are in place to maintain interest rate risk at prudent levels with consistency and continuity. In evaluating the quantitative level of interest rate risk, the Corporation assesses the existing and potential future effects of changes in interest rates on its financial condition, including capital adequacy, earnings, liquidity, and asset quality.

In addition to changes in interest rates, the level of future net interest income is also dependent on a number of variables, including: the growth, composition and levels of loans, deposits, and other earning assets and interest-bearing obligations, and economic and competitive conditions; potential changes in lending, investing, and deposit strategies; customer preferences; and other factors.

FOREIGN EXCHANGE RISK

In addition to managing interest rate risk, management also actively manages risk associated with foreign exchange. The Corporation provides foreign exchange services, makes loans to, and accepts deposits from, Canadian customers primarily at its banking offices in Sault Ste. Marie, Michigan. To protect against foreign exchange risk, the Corporation monitors the volume of Canadian deposits it takes in and then invests these Canadian funds in Canadian commercial loans and securities. Management believes the exposure to short-term foreign exchange risk is minimal and at an acceptable level for the Corporation.

OFF-BALANCE-SHEET RISK

Derivative financial instruments include futures, forwards, interest rate swaps, option contracts and other financial instruments with similar characteristics. The Corporation currently does not enter into futures, forwards, swaps, or options. However, the Corporation is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit and involve to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the condensed consolidated balance sheets. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates and may require collateral from the borrower if deemed necessary by the Corporation. Standby letters of credit are conditional commitments issued by the Corporation to guarantee the performance of a customer to a third party up to a stipulated amount and with specified terms and conditions.

Commitments to extend credit and standby letters of credit are not recorded as an asset or liability by the Corporation until the instrument is exercised.

IMPACT OF INFLATION AND CHANGING PRICES

The accompanying condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles, which require the measurement of financial position and results of operations in historical dollars without considering the change in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of the Corporation’s operations. Nearly all the assets and liabilities of the Corporation are financial, unlike industrial or commercial companies. As a result, the Corporation’s performance is directly impacted by changes in interest rates, which are indirectly influenced by inflationary expectations. The Corporation’s ability to match the interest sensitivity of its financial assets to the interest sensitivity of its financial liabilities tends to minimize the effect of changes in interest rates on the Corporation’s performance. Changes in interest rates do not necessarily move to the same extent as changes in the price of goods and services.

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Item 4. Controls and Proceedures

As of June 30, 2014, we carried out an evaluation, under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-15 of the Securities Exchange Act of 1934. Our management, which includes our principal executive officer and our principal financial officer, does not expect that our disclosure controls and procedures will prevent all errors and all fraud.

A control system, no matter how well conceived and operated, can provide only reasonable, but not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints; additionally, the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Corporation have been detected. These inherent limitations include the realities that judgments in decision making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is also based, in part, upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate due to changes in conditions; also the degree of compliance with policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. Our principal executive officer and principal accounting officer have concluded, based on our evaluation of our disclosure controls and procedures, that our disclosure controls and procedures, as defined, under Rule 13a-15 of the Securities Exchange Act of 1934 are effective as of June 30, 2014.

Changes in Internal Control Over Financial Reporting

There were no changes in the Corporation’s internal control over financial reporting that occurred during the quarter ended June 30, 2014 that have materially affected, or are reasonably likely to materially affect, the Corporation’s internal control over financial reporting.

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PART II. OTHER INFORMATION

Item 1. Legal Proceedings

The Corporation and its subsidiaries are subject to routine litigation incidental to the business of banking.

Item2. Unregistered Sales of Equity Securities and Use of Proceeds

The Corporation currently has a share repurchase program. The program is conducted under authorizations from time to time by the Board of Directors. The shares reported in the table below are covered by Board authorizations made and publically announced for $600,000 on February 27, 2013 and an additional $600,000 on December 17, 2013. Neither of these authorizations has an expiration date.

Issuer purchase of Equity Securities

				Total number of
				shares purchased	Maximum
				as part of a	dollars
				publically	yet to
	Total number of	Average price		announced	be used for
Period of purchases (1)	shares purchased	paid per share		plan or program	stock purchases

January 1, 2014 to January 31, 2014	9,200	$	10.19	9,200	$	595,874
February 1, 2014 to February 28, 2014	4,500	$	11.00	4,500	546,368
March 1, 2014 to March 31, 2014	—	$	—	—	546,368

Total First Quarter 2014	13,700	$	10.50	13,700

(1) Monthly information is provided for the Corporation’s fiscal months during the first quarter of 2014. There were no purchases made during the second quarter of 2014

Item 6. Exhibits and Reports on Form 8-K

(a) Exhibits:

Exhibit 31.1		Rule 13a-14(a) Certification of Chief Executive Officer.

Exhibit 31.2		Rule 13a-14(a) Certification of Chief Financial Officer.

Exhibit 32.1		Section 1350 Certification of Chief Executive Officer.

Exhibit 32.2		Section 1350 Certification of Chief Financial Officer.

101.INS		XBRL Instance Document.

101.SCH		XBRL Taxonomy Extension Schema Document.

101.CAL		XBRL Taxonomy Extension Calculation Linkbase Document.

101.DEF		XBRL Taxonomy Extension Definition Linkbase Document.

101.LAB		XBRL Taxonomy Extension Labels Linkbase Document.

101.PRE		XBRL Taxonomy Extension Presentation Linkbase Document.

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SIGNATURES

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

		MACKINAC FINANCIAL CORPORATION
		(Registrant)


Date:	August 14, 2014	By:	/s/ Paul D. Tobias
			PAUL D. TOBIAS,
			CHAIRMAN AND CHIEF EXECUTIVE OFFICER
			(principal executive officer)


		By:	/s/ Ernie R. Krueger
			ERNIE R. KRUEGER
			EVP/CHIEF FINANCIAL OFFICER
			(principal financial and accounting officer)