UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2008

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE EXCHANGE ACT

For the transition period from                      to                     

Fentura Financial, Inc.

(Exact name of registrant as specified in its charter)

Michigan		38-2806518
(State or other jurisdiction of		(IRS Employee Identification No.)
incorporation or organization)

(Address of Principal Executive Offices)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. þ Yes o No

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 the 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 (Do not check if a smaller reporting company)		Smaller reporting company þ

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: October 24, 2008

Class — Common Stock       Shares Outstanding — 2,181,285

 

 

Fentura Financial Inc.
Index to Form 10-Q

		Page
Part I — Financial Information			3
Item 1 — Consolidated Financial Statements (Unaudited)			3-13
Item 2 — Management’s Discussion and Analysis of Financial Condition and Results of Operations			14-27
Item 3 — Quantitative and Qualitative Disclosures about Market Risk			28-30
Item 4T — Controls and Procedures			31
Part II — Other Information			32-33
Item 1 — Legal Proceedings			32
Item 1A — Risk Factors			32
Item 2 — Unregistered Sales of Equity Securities and Use of Proceeds			32
Item 3 — Defaults Upon Senior Securities			32
Item 4 —Submission of Matters to a Vote of Security Holders			32
Item 5 — Other Information			32
Item 6 — Exhibits			32-33
Signatures			34
Exhibit Index			35
EX-31.1
EX-31.2
EX-32.1
EX-32.2

PART I — FINANCIAL INFORMATION

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS

Fentura Financial, Inc.
Consolidated Balance Sheets

		September 30,				Dec 31,
		2008				2007
(000’s omitted except share data)		(unaudited)
ASSETS
Cash and due from banks		$	13,979			$	22,734
Federal funds sold			5,600				7,300
Total cash & cash equivalents			19,579				30,034
Securities-available for sale			54,921				71,792
Securities-held to maturity, (fair value of $8,070 at September 30, 2008 and $8,714 at December 31, 2007)			8,099				8,685
Total securities			63,020				80,477
Loans held for sale			1,461				1,655
Loans:
Commercial			308,029				313,642
Real estate loans — construction			54,730				59,805
Real estate loans — mortgage			38,746				39,817
Consumer loans			57,298				58,139
Total loans			458,803				471,403
Less: Allowance for loan losses			(11,342	)			(8,554	)
Net loans			447,461				462,849
Bank Owned Life Insurance			7,201				7,042
Bank premises and equipment			19,006				20,101
Federal Home Loan Bank stock			2,032				2,032
Accrued interest receivable			2,509				2,813
Goodwill			7,955				7,955
Acquisition intangibles			335				485
Equity Investment			2,392				3,089
Other Real Estate Owned			6,917				2,003
Other assets			7,490				7,484
Total Assets		$	587,358			$	628,019
LIABILITIES
Deposits:
Non-interest bearing deposits		$	73,867			$	75,148
Interest bearing deposits			434,257				468,355
Total deposits			508,124				543,503
Short term borrowings			2,375				649
Federal Home Loan Bank Advances			15,007				11,030
Repurchase Agreements			0				5,000
Subordinated debentures			14,000				14,000
Accrued taxes, interest and other liabilities			1,651				4,341
Total liabilities			541,157				578,523
SHAREHOLDERS’ EQUITY
Common stock — no par value 2,180,571 shares issued (2,163,385 at Dec. 31, 2007)			42,738				42,478
Retained earnings			4,987				7,488
Accumulated other comprehensive income (loss)			(1,524	)			(470	)
Total shareholders’ equity			46,201				49,496
Total Liabilities and Shareholders’ Equity		$	587,358			$	628,019

See notes to consolidated financial statements.

Fentura Financial, Inc.
Consolidated Statements of Income (Unaudited)

		Three Months Ended								Nine Months Ended
		September 30								September 30
(000’s omitted except per share data)		2008				2007				2008				2007
INTEREST INCOME
Interest and fees on loans		$	7,582			$	8,796			$	23,143			$	26,360
Interest and dividends on securities:
Taxable			523				786				1,716				2,504
Tax-exempt			161				169				429				564
Interest on federal funds sold			42				40				156				251
Total interest income			8,308				9,791				25,444				29,679
INTEREST EXPENSE
Deposits			3,109				4,147				10,421				12,098
Borrowings			366				547				1,301				1,692
Total interest expense			3,475				4,694				11,722				13,790
NET INTEREST INCOME			4,833				5,097				13,722				15,889
Provision for loan losses			736				5,144				5,628				6,232
Net interest income after Provision for loan losses			4,097				(47	)			8,094				9,657
NON-INTEREST INCOME
Service charges on deposit accounts			802				860				2,291				2,547
Gain on sale of mortgage loans			42				65				260				268
Trust and investment services income			458				471				1,432				1,439
Other income and fees			43				574				619				1,609
Total non-interest income			1,345				1,970				4,602				5,863
NON-INTEREST EXPENSE
Salaries and employee benefits			2,683				2,868				8,620				9,308
Occupancy			492				543				1,574				1,556
Furniture and equipment			478				532				1,508				1,591
Loan and collection			173				111				718				287
Advertising and promotional			114				125				363				396
Loss on security impairment			233				0				843				0
Other operating expenses			1,045				1,057				3,157				3,192
Total non-interest expense			5,218				5,236				16,783				16,330
INCOME (LOSS) BEFORE TAXES			224				(3,313	)			(4,087	)			(810	)
Federal income taxes/(benefit)			(71	)			(1,206	)			(1,586	)			(495	)
NET INCOME (LOSS)		$	295			$	(2,107	)		$	(2,501	)		$	(315	)
Per share:
Net income (loss) — basic		$	0.14			$	(0.98	)		$	(1.15	)		$	(0.15	)
Net income (loss) — diluted		$	0.14			$	(0.98	)		$	(1.15	)		$	(0.15	)
Cash Dividends declared		$	0.00			$	0.25			$	0.00			$	0.75

See notes to consolidated financial statements.

Fentura Financial, Inc.
Consolidated Statements of Changes in Shareholders’ Equity (Unaudited)

		Nine Months Ended
		September 30,
(000’s omitted)		2008				2007
COMMON STOCK
Balance, beginning of period		$	42,478			$	42,158
Issuance of shares under
Director stock purchase plan & Dividend reinvestment program (17,186 and 11,799 shares)			254				628
Stock repurchase (0 and 17,184 shares)			0				(520	)
Stock options exercised (0 and 295 shares)			0				6
Stock compensation expense			6				32
Balance, end of period			42,738				42,304
RETAINED EARNINGS
Balance, beginning of period			7,488				10,118
Net income (loss)			(2,501	)			(315	)
Cash dividends declared			0				(1,623	)
Balance, end of period			4,987				8,180
ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)
Balance, beginning of period			(470	)			(958	)
Change in unrealized gain (loss) on securities available for sale, net of tax			(1,054	)			537
Balance, end of period			(1,524	)			(421	)
TOTAL SHAREHOLDERS’ EQUITY		$	46,201			$	50,063

See notes to consolidated financial statements.

		Nine Months Ended
		September 30,
(000’s omitted)		2008				2007
OPERATING ACTIVITIES:
Net income (loss)		$	(2,501	)		$	(315	)
Adjustments to reconcile net income (loss) to cash Provided by Operating Activities:
Stock compensation expense			6				32
Depreciation and amortization			663				1,396
Provision for loan losses			5,628				6,232
Loans originated for sale			(19,918	)			(13,505	)
Proceeds from the sale of loans			20,372				13,650
(Gain) Loss on sales of loans			(260	)			(268	)
Gain (Loss) on sale of fixed assets			(118	)			0
Loss on security impairment			843				0
Loss on equity investment			697				0
Earnings from bank owned life insurance			(159	)			(159	)
Net (increase) decrease in interest receivable & other assets			2,317				(5,159	)
Net increase (decrease) in interest payable & other liabilities			(2,152	)			(1,881	)
Total Adjustments			7,919				338
Net Cash Provided By (Used In) Operating Activities			5,418				23
Cash Flows From Investing Activities:
Proceeds from maturities of securities — AFS			7,441				1,649
Proceeds from maturities of securities — HTM			1,332				12,744
Proceeds from calls of securities — AFS			12,662				4,700
Proceeds from calls of securities — HTM			0				140
Proceeds from sales of securities — AFS			1,999				0
Purchases of securities — AFS			(7,067	)			(4,571	)
Purchases of securities — HTM			(750	)			0
Net (increase) decrease in loans			2,843				(17,533	)
Sales of Other Real Estate Owned			2,782				1,022
Acquisition of premises and equipment, net			89				(3,746	)
Net Cash Provided By (Used in) Investing Activities			18,549				(5,595	)
Cash Flows From Financing Activities:
Net increase (decrease) in deposits			(35,379	)			1,379
Net increase (decrease) in short term borrowings			1,726				3,750
Net increase (decrease) in repurchase agreements			(5,000	)			(5,000	)
Purchase of advances from FHLB			27,001				7,000
Repayments of advances from FHLB			(23,024	)			(7,022	)
Net proceeds from stock issuance and purchase			254				114
Cash dividends			0				(1,623	)
Net Cash Provided By (Used In) Financing Activities			(34,422	)			(1,402	)
NET CHANGE IN CASH AND CASH EQUIVALENTS		$	(10,455	)		$	(6,974	)
CASH AND CASH EQUIVALENTS — BEGINNING		$	30,034			$	29,446
CASH AND CASH EQUIVALENTS — ENDING		$	19,579			$	22,472
CASH PAID FOR:
INTEREST		$	11,388			$	13,789
INCOME TAXES		$	0			$	450
NONCASH DISCLOSURES:
Transfers from loans to other real estate		$	6,917			$	147

See notes to consolidated financial statements

Fentura Financial, Inc.
Consolidated Statements of Comprehensive Income (Unaudited)

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
(000’s Omitted)		2008				2007				2008				2007
Net Income (loss)		$	295			$	(2,107	)		$	(2,501	)		$	(315	)
Other comprehensive income (loss), net of tax:
Unrealized holding gains (losses) arising during period			(869	)			618				(1,896	)			537
Less: Impairment loss recognized during period			(233	)			0				(843	)			0
Other comprehensive income (loss)			(636	)			618				(1,053	)			537
Comprehensive income (loss)		$	(341	)		$	(1,489	)		$	(3,554	)		$	222

Fentura Financial, Inc.
Notes to Consolidated Financial Statements (Unaudited)

Note 1 Basis of Presentation

The consolidated financial statements at December 31, 2007 and September 30, 2008 include Fentura Financial, Inc. (the “Corporation”) and its wholly owned subsidiaries, The State Bank in Fenton, Michigan; Davison State Bank in Davison, Michigan; and West Michigan Community Bank in Hudsonville, Michigan (the “Banks”), as well as Fentura Mortgage Company, West Michigan Mortgage Company, LLC, and the other subsidiaries of the Banks. Intercompany transactions and balances are eliminated in consolidation.

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and the instructions for Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States of America 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 nine months ended September 30, 2008 are not necessarily indicative of the results that may be expected for the year ending December 31, 2008. For further information, refer to the consolidated financial statements and footnotes thereto included in the Corporation’s annual report on Form 10-K for the year ended December 31, 2007.

Reclassifications: Some items in the prior year financial statements were reclassified to conform to the current presentation.

Securities: Securities are classified as held to maturity and carried at amortized cost when management has the positive intent and ability to hold them to maturity. Securities are classified as available for sale when they might be sold before maturity. Securities available for sale are carried at fair value, with unrealized holding gains and losses reported in other comprehensive income.

Interest income includes amortization of purchase premium or discount. Premiums and discounts on securities are amortized on the level-yield method without anticipating prepayments. Gains and losses on sales are based on the amortized cost of the security sold. Securities are written down to fair value when a decline in fair value is not temporary.

Declines in the fair value of securities below their cost that are other than temporary are reflected as realized losses. In estimating other-than-temporary losses, management considers: the length of time and extent the fair value has been less than cost, the financial condition and near term prospects of the issuer, and the Corporation’s ability and intent to hold the security for a period sufficient to allow for any anticipated recovery in fair value.

Allowance for Loan Losses: The allowance for loan losses is a valuation allowance for probable incurred credit losses, increased by the provision for loan losses and decreased by charge-offs less recoveries. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged-off. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed.

A loan is impaired when full payment under the loan terms is not expected. Impairment is evaluated in total for smaller-balance loans of similar nature such as residential mortgage, consumer, and on an individual loan basis for other loans. If a loan is impaired, a portion of the allowance is allocated 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.

Stock Option Plans

The Nonemployee Director Stock Option Plan provides for granting options to nonemployee directors to purchase the Corporation’s common stock. No options have been granted in 2008. The purchase price of the shares is the fair market value at the date of the grant, and there is a three-year vesting period before options may be exercised. Options to acquire no more than 8,131 shares of stock may be granted under the Plan in any calendar year and options to acquire not more than 73,967 shares in the aggregate may be outstanding at any one time.

The Employee Stock Option Plan grants options to eligible employees to purchase the Corporation’s common stock at or above, the fair market value of the stock at the date of the grant. Awards granted under this plan are limited to an aggregate of 86,936 shares. The administrator of the plan is a committee of directors. The administrator has the power to determine the number of options to be granted, the exercise price of the options and other terms of the options, subject to consistency with the terms of the Plan.

The following table summarizes stock option activity:

		Number of				Weighted
		Options				Average Price
Options outstanding at December 31, 2007			40,228			$	29.74
Options forfeited 2008			(12,722	)		$	29.94
Options outstanding at September 30, 2008			27,506			$	29.64

Note 2 Adoption of New Accounting Standards

Fair Value Option and Fair Value Measurements

In September 2006, the FASB issued Statement No. 157, Fair Value Measurements. This Statement defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. This Statement establishes a fair value hierarchy about the assumptions used to measure fair value and clarifies assumptions about risk and the effect of a restriction on the sale or use of an asset. The standard was effective for fiscal years beginning after November 15, 2007. In February 2008, the FASB issued Staff Position (FSP) 157-2, Effective Date of FASB Statement No. 157. This FSP delays the effective date of FAS 157 for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value on a recurring basis (at least annually) to fiscal years beginning after November 15, 2008, and interim periods within those fiscal years. The Corporation adopted the standard effective January 1, 2008 and applicable disclosures have been added to the Notes to Consolidated Financial Statements. On October 10, 2008 the FASB issued FSP 157-3, Determining the Fair Value of a Financial Asset when the Market for that Asset is not Active, which illustrates key considerations in determining the fair value of a financial asset when the market for that asset is not active. The FSP provides clarification for how to consider various inputs in determining fair value under current market conditions consistent with the principles of FAS 157.

In February 2007, the FASB issued Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. The standard provides companies with an option to report selected financial assets and liabilities at fair value and establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. The Corporation did not elect the fair value option for any financial assets or financial liabilities as of January 1, 2008, the effective date of the standard.

Note 3 Fair Value

Statement No. 157 establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:

Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing and asset or liability.

The fair values of securities available for sale are determined by obtaining quoted prices on nationally recognized securities exchanges (Level 1 inputs) or matrix pricing, which is a mathematical technique widely used to in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities (Level 2 inputs).

Assets and Liabilities Measured on a Recurring Basis

Assets and liabilities measured at fair value on a recurring basis are summarized below:

Fair Value Measurements at September 30, 2008 Using

Quoted Prices

in Active

Significant Other

Significant

Markets for

Observable

Unobservable

September

Identical Assets

Inputs

Inputs

(000’s omitted)

30, 2008

(Level 1)

(Level 2)

(Level 3)

Assets:

Available for sale securities

$

54,921

$

10

$

53,374

$

1,537

Level 1 assets are comprised of investments in other financial institutions, which are publicly traded on the open market.

Level 2 assets are comprised of available for sale securities including, U.S. Treasuries, Government Agencies and Municipal Securities.

Level 3 assets are comprised of investments in other financial institutions including DeNovo banks.

The table below presents a reconciliation and income statement classification of gains and losses for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the nine month period ended September 30, 2008:

		Fair Value Measurements Using Significant
						Unobservable Inputs
						(Level 3)
(000’s omitted)		Asset				Liability				Total
Beginning balance, Jan. 1, 2008		$	2,721			$	0			$	2,721
Total gains or losses (realized / unrealized)
Included in earnings Loss on security impairment			(843	)			0				(843	)
Included in other comprehensive income			(341	)			0				(341	)
Transfers in and / or out of Level 3			0				0				0
Ending balance, September 30, 2008		$	1,537			$	0			$	1,537

Assets and Liabilities Measured on a Non-Recurring Basis

Assets and liabilities measured at fair value on a non-recurring basis are summarized below:

Fair Value Measurements at September 30, 2008 Using

Significant

Quoted Prices in

Other

Significant

Active Markets for

Observable

Unobservable

September

Identical Assets

Inputs

Inputs

(000’s omitted)

30, 2008

(Level 1)

(Level 2)

(Level 3)

Assets:

Impaired loans

$

17,092

$

0

$

0

$

17,092

The following represent impairment charges recognized during the period:

Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a carrying amount of $40,493,000, with a valuation allowance of $5,163,000, resulting in an additional provision for loan losses of $995,000 for the period. If a loan is impaired, a portion of the allowance is allocated 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.

Note 4 Securities

During the quarter ended September 30, 2008, the Corporation recognized a $233,400 other-than-temporary impairment loss on one of its DeNovo bank investments. The institution experienced a net operating loss for 2007 and for the first nine months of 2008. The 2008 year to date other-than-temporary impairment recognition on this investment totals $843,200, the full investment amount. This investment was in an unrealized loss position at December 31, 2007 and since such time; its unrealized loss has continued to increase. The book value of this investment was $843,200 and its market value was 18.5% less at December 31, 2007. Throughout 2007 and into 2008, this institution, based in Michigan, has experienced credit quality deterioration. The De Novo Bank has since been closed by regulatory authorities.

Note 5 Allowance for Loan Losses

Activity in the allowance for loan losses for the nine month period ended September 30, 2008 and 2007 is as follows (in thousands):

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
			2008				2007				2008				2007
Balance, beginning of period		$	12,778			$	7,174			$	8,554			$	6,692
Provision for loan losses			736				5,144				5,628				6,232
Loans charged off			(2,369	)			(948	)			(3,302	)			(1,703	)
Loan recoveries			197				55				462				204
Balance, end of period		$	11,342			$	11,425			$	11,342			$	11,425

Loan impairment is measured by estimating the expected future cash flows and discounting them at the respective effective interest rate or by valuing the underlying collateral. The recorded investment in these loans is as follows at September 30, 2008 and December 31, 2007 (in thousands):

		September 30,				December 31,
		2008				2007
Period end loans not requiring allocation		$	18,238			$	11,197
Period end loans requiring allocation			22,255				18,186
		$	40,493			$	29,383
Amount of the allowance for loan losses allocated		$	5,163			$	2,751

Loans for which the accrual of interest has been discontinued at September 30, 2008 and December 31, 2007 amounted to $16,240,000 and $13,056,000, respectively, and are included in the impaired loans above. Loans past due, greater than 90 days and still accruing interest, amounted to $3,876,000 at September 30, 2008 and $54,000 at December 31, 2007.

Note 6 Earnings Per Common Share

A reconciliation of the numerators and denominators used in the computation of basic earnings per common share and diluted earnings per common share is presented below. Earnings per common share are presented below for the three and nine month periods ended September 30, 2008 and 2007:

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
($ in thousands except per share data)		2008				2007				2008				2007
Basic Earnings Per Common Share:
Numerator
Net Income (loss)		$	295			$	(2,107	)		$	(2,501	)		$	(315	)
Denominator
Weighted average common shares Outstanding			2,175,786				2,158,623				2,171,758				2,159,536
Basic earnings (loss) per common share		$	0.14			$	(0.98	)		$	(1.15	)		$	(0.15	)
Diluted Earnings Per Common Share:
Numerator
Net Income (loss)		$	295			$	(2,107	)		$	(2,501	)		$	(315	)
Denominator
Weighted average common shares Outstanding for basic earnings per Common share			2,175,786				2,158,623				2,171,758				2,159,536
Add: Dilutive effects of assumed exercises of stock options			0				0				0				0
Weighted average common shares and dilutive potential common shares outstanding			2,175,786				2,158,623				2,171,758				2,159,536
Diluted earnings (loss) per common share		$	0.14			$	(0.98	)		$	(1.15	)		$	(0.15	)

Stock options for 27,506 shares and 27,325 shares of common stock for the three and nine month period ended September 30, 2008 and stock options for 22,724 shares and 21,140 shares of common stock for the three and nine month period ended September 30, 2007 were not considered in computing diluted earnings per common share because they were antidilutive.

Note 7 Commitments and Contingencies

There are various contingent liabilities that are not reflected in the financial statements including claims and legal actions arising in the ordinary course of business. In the opinion of management, after consultation with legal counsel, the ultimate disposition of these matters is not expected to have a material effect on the Corporation’s consolidated financial condition or results of operations.

Note 8 Participation in the Treasury Capital Purchase Program

On October 3, 2008, Congress passed the Emergency Economic Stabilization Act of 2008 (EESA), which provides the U. S. Secretary of the Treasury with broad authority to implement certain actions to help restore stability and liquidity to U.S. markets. One of the provisions resulting from the Act is the Treasury Capital Purchase Program (CPP), which provides direct equity investment of perpetual preferred stock by the Treasury in qualified financial institutions. The program is voluntary and requires an institution to comply with a number of restrictions and provisions, including limits on executive compensation, stock redemptions and declaration of dividends. Applications must be submitted by November 14, 2008 and are subject to approval by the Treasury. The CPP provides for a minimum investment of 1% of Risk-Weighted Assets, with a maximum investment equal to the lesser of 3 percent of Total Risk-Weighted Assets or $25 billion. The perpetual preferred stock investment will have a dividend rate of 5% per year, until the fifth anniversary of the Treasury investment, and a dividend of 9%, thereafter. The CPP also requires the Treasury to receive warrants for common stock equal to 15% of the capital invested by the Treasury. The Company is considering filing an application to participate in this program and will weigh the benefits of this option before proceeding.

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

Results of Operations

Certain of the Corporation’s accounting policies are important to the portrayal of the Corporation’s financial condition, since they require management to make difficult, complex or subjective judgments, some of which may relate to matters that are inherently uncertain. Estimates associated with these policies are susceptible to material changes as a result of changes in facts and circumstances. Facts and circumstances, which could affect these judgments, include, but without limitation, changes in interest rates, in the performance of the economy or in the financial condition of borrowers. Management believes that its critical accounting policies include determining the allowance for loan losses and determining the fair value of securities and other financial instruments.

As indicated in the income statement, the net income for the three months ended September 30, 2008 was $295,000 compared to net loss of ($2,107,000) for the same period in 2007. Net interest income in the third quarter of 2008, was $264,000 below net interest income for the same quarter in 2007. This is primarily due to a 14.3% decrease in interest income from declining market rates and an increase in non-performing loans that were put on non-accrual during the first nine months of 2008. Additionally, a decrease in non-interest income and a modest decrease in non-interest expense for the third quarter of 2008 also contributed to the third quarter income. The third quarter 2008 provision for loan losses was down $4.4 million compared to third quarter of 2007. The decrease in provision is due to the banks previously writing down properties to current market conditions. These conditions have negatively impacted borrower capacity to repay their obligations and have led to declining real estate values pertinent to loan collateral. Management feels that the allowance for loan losses, which has increased $2,788,000 from December 31, 2007, adequately covers the identified credit risk at September 30, 2008.

The Corporation had an original $843,200 investment in a DeNovo bank carried as available for sale. At December 31, 2007, the estimated fair value of this investment was $687,600. The prior period losses have been recorded through other comprehensive income in accordance with available for sale security accounting. Late in the first quarter of 2008, the DeNovo bank made information available that indicated its financial losses were beyond normal start up losses and management began to conduct a detailed evaluation. Management has continued to gather more information about the DeNovo bank’s performance and management has concluded that a recovery could no longer be forecasted. Accordingly an other-than-temporary impairment loss of $574,400 was recognized through earnings in the first quarter of 2008. The Corporation recorded another other-than-temporary impairment loss of $35,400 in the second quarter of 2008. The Corporation has recorded the final other-than-temporary impairment loss of $233,400 in the third quarter of 2008. As a result of this action the investment has been fully written off. During the third quarter of 2008, this DeNovo bank was taken-over by the FDIC.

The banking industry uses standard performance indicators to help evaluate a banking institution’s performance. Return on average assets is one of these indicators. For the three months ended September 30, 2008, the Corporation’s return on average assets (annualized) was 0.01% compared to (0.34%) for the same period in 2007. For nine months ended September 30, 2008, the Corporation’s return on average assets (annualized) was (0.31%) compared to (0.05%) for the same period in 2007. Net income (loss) per share—basic and diluted was $0.14 in the third quarter of 2008 compared to ($0.98) net income (loss) per share basic and diluted for the same period in 2007. Net income (loss) per share — basic and diluted was ($1.15) for the nine months ended September 30, 2008 compared to ($0.15) net income per share basic and diluted for the same period in 2007.

Net Interest Income

Net interest income and average balances and yields on major categories of interest-earning assets and interest-bearing liabilities for the nine months ended September 30, 2008 and 2007 are summarized in Table 2. Table 3 summarizes net interest income, average balances and yields on major categories of interest-earning assets and interest-earning liabilities for the three months ended September 30, 2008 and 2007. The effects of changes in average interest rates and average balances are detailed in Table 1 below.

Table 1

		NINE MONTHS ENDED
		SEPTEMBER 30,
		2008 COMPARED TO 2007
		INCREASE (DECREASE)
		DUE TO
						YIELD/
(000’S OMITTED)		VOL				RATE				TOTAL
Taxable Securities		$	(759	)		$	(35	)		$	(794	)
Tax-Exempt Securities			(127	)			(77	)			(204	)
Federal Funds Sold			58				(153	)			(95	)
Total Loans			558				(3,761	)			(3,203	)
Loans Held for Sale			(10	)			(6	)			(16	)
Total Earning Assets			(280	)			(4,032	)			(4,312	)
Interest Bearing Demand Deposits			(60	)			(667	)			(727	)
Savings Deposits			(48	)			(261	)			(309	)
Time CD’s $100,000 and Over			325				(256	)			69
Other Time Deposits			(258	)			(452	)			(710	)
Other Borrowings			(134	)			(257	)			(391	)
Total Interest Bearing Liabilities			(175	)			(1,893	)			(2,068	)
Net Interest Income		$	($105	)		$	(2,139	)		$	(2,244	)

Table 1 illustrates the changes in earning asset and interest bearing liability volumes and rates from year to year. The decrease in net interest income was a result of a decrease in yields and rates on loans and interest bearing liabilities. Management worked to counter the decrease in yield on earning assets with reductions in interest bearing liability rates, however the latitude of allowable rate movement on liabilities was less than on assets.

Net interest income (displayed with consideration of full tax equivalency), average balance sheet amounts, and the corresponding yields for the three months ended September 30, 2008 and 2007 are shown in Table 3. Net interest income for the three months ended September 30, 2008 was $4,935,000, a decrease of $269,000, or 5.2%, over the same period in 2007. Net interest margin decreased due to a rapid decrease in interest income which was partially offset by decreases in interest bearing deposits. However, the decrease in interest expense was limited by the maturity of time deposits and their ability to re-price. Management has re-priced deposits to be competitive in the respective markets. Additionally, increases in non-accruing loans, to a total of $16,240,000, have had a negative impact to interest income. Loan pricing continues to be competitive. While management strives to acquire quality credits with favorable pricing, local competition has been driving loan pricing down to marginal levels. As a result, the Banks have opted not to acquire minimally priced loans. Management has also addressed credit quality issues during the past four quarters. This will be discussed further in the “Allowance and Provision for Loan Losses” section.

Management reviews economic forecasts and strategy on a monthly basis. Accordingly, the Corporation will continue to strategically manage the balance sheet structure in an effort to create stability in net interest income. The Corporation expects to continue to seek out new loan opportunities with a focus on sound credit quality.

As indicated in Table 2, for the nine months ended September 30, 2008, the Corporation’s net interest margin (with consideration of full tax equivalency) was 3.38% compared with 3.84% for the same period in 2007. This decrease is a result of declines in interest income which primarily was due to decreases in yields on loans. The decrease in interest income was partially due to an increase in loans placed into non-accrual status. Those decreases outpaced the repricing ability of interest bearing liabilities, due to the large proportion of time deposits.

As indicated in Table 3, for the three months ended September 30, 2008, the Corporation’s net interest margin (with consideration of full tax equivalency) was 3.60% compared with 3.66% for the same period in 2007. This decrease is a result of declines in interest income, due to an increase in loans placed into non-accrual status, versus the re-pricing ability of interest bearing liabilities.

Average earning assets decreased 2.3% or approximately $13,050,000 comparing the nine months of 2008 to the same time period in 2007. Loans, the highest yielding component of earning assets, represented 84.8% of earning assets in 2008 compared to 80.9% in 2007. Average interest bearing liabilities decreased 1.8% or $9,035,000 comparing the first nine months of 2008 to the same time period in 2007. Non-interest bearing deposits amounted to 13.4% of average earning assets in the first nine months of 2008 compared with 13.3% in the same time period of 2007. For the third quarter of 2008 compared to 2007, average earning assets decreased 3.3% or $18,716,000. The largest decrease was in the investment securities portfolio, as the funds were used to fund loans and repay borrowings. Loans increased 0.1% or $3,014,000 comparing the third quarter of 2008 to the third quarter of 2007. Loans represented 85.5% of earning assets in 2008 compared to 82.1% in 2007. Average interest bearing liabilities decreased $18,359,000 or 3.8% comparing the third quarter of 2008 to 2007. Non-interest bearing liabilities were 13.9% of average earning assets for the third quarter of 2008 versus 13.4% in the third quarter of 2007.

Management continually monitors the Corporation’s balance sheet in an effort to insulate net interest income from significant swings caused by interest rate volatility. If market rates change in 2008, corresponding changes in funding costs will be considered to avoid the potential negative impact on net interest income. The Corporation’s policies in this regard are further discussed in the section titled “Interest Rate Sensitivity Management.”

Table 2 Average Balance and Rates

		NINE MONTHS ENDED September 30,
		2008												2007
		AVERAGE				INCOME/				YIELD/				AVERAGE				INCOME/				YIELD/
(000’s omitted)(Annualized)		BALANCE				EXPENSE				RATE				BALANCE				EXPENSE				RATE
ASSETS
Securities:
U.S. Treasury and Government Agencies		$	51,484			$	1,618				4.20	%		$	75,448			$	2,436				4.32	%
State and Political (1)			15,727				650				5.52	%			18,434				854				6.20	%
Other			7,661				99				1.73	%			6,086				75				1.63	%
Total Securities			74,872				2,367				4.22	%			99,968				3,365				4.50	%
Fed Funds Sold			8,056				156				2.59	%			6,544				251				5.13	%
Loans:
Commercial			369,330				18,124				6.55	%			356,794				20,556				7.70	%
Tax Free (1)			3,247				162				6.67	%			3,659				179				6.55	%
Real Estate-Mortgage			38,428				1,851				6.43	%			37,340				1,893				6.78	%
Consumer			57,901				3,006				6.93	%			60,367				3,718				8.23	%
Total loans			468,906				23,143				6.59	%			458,160				26,346				7.69	%
Allowance for Loan Losses			(10,336	)											(7,275	)
Net Loans			458,570				23,143				6.74	%			450,885				26,346				7.81	%
Loans Held for Sale			1,189				53				5.95	%			1,401				69				6.58	%
TOTAL EARNING ASSETS		$	553,023			$	25,719				6.21	%		$	566,073			$	30,031				7.09	%
Cash Due from Banks			15,334												17,181
All Other Assets			47,296												44,361
TOTAL ASSETS		$	605,317											$	620,340
LIABILITIES & SHAREHOLDERS’ EQUITY:
Deposits:
Interest bearing – DDA		$	96,623			$	1,064				1.47	%		$	99,850			$	1,791				2.40	%
Savings Deposits			84,690				574				0.91	%			89,413				883				1.32	%
Time CD’s $100,000 and Over			145,959				5,199				4.76	%			136,922				5,130				5.01	%
Other Time CD’s			118,013				3,584				4.06	%			125,267				4,294				4.58	%
Total Deposits			445,285				10,421				3.13	%			451,452				12,098				3.58	%
Other Borrowings			34,190				1,301				5.08	%			37,058				1,692				6.10	%
INTEREST BEARING LIABILITIES		$	479,475			$	11,722				3.27	%		$	488,510			$	13,790				3.77	%
Non-Interest bearing – DDA			73,974												75,106
All Other Liabilities			2,934												4,029
Shareholders’ Equity			48,934												52,695
TOTAL LIABILITIES & SHAREHOLDERS’ EQUITY		$	605,317											$	620,340
Net Interest Rate Spread											2.95	%											3.32	%
Net Interest Income /Margin						$	13,997				3.38	%						$	16,241				3.84	%

Table 3 Average Balance and Rates

		THREE MONTHS ENDED September 30,
		2008												2007
		AVERAGE				INCOME/				YIELD/				AVERAGE				INCOME/				YIELD/
(000’s omitted)(Annualized)		BALANCE				EXPENSE				RATE				BALANCE				EXPENSE				RATE
ASSETS
Securities:
U.S. Treasury and Government Agencies		$	46,531			$	490				4.19	%		$	71,918			$	764				4.21	%
State and Political (1)			16,227				244				5.98	%			16,464				255				6.15	%
Other			7,016				32				1.81	%			8,458				25				1.18	%
Total Securities			69,774				766				4.37	%			96,840				1,044				4.28	%
Fed Funds Sold			8,863				42				1.89	%			3,201				40				4.97	%
Loans:
Commercial			367,472				5,971				6.46	%			360,654				6,840				7.52	%
Tax Free (1)			3,183				53				6.63	%			3,484				58				6.55	%
Real Estate-Mortgage			37,522				595				6.31	%			39,465				669				6.72	%
Consumer			57,818				970				6.67	%			59,378				1,230				8.22	%
Total loans			465,995				7,589				6.48	%			462,981				8,797				7.54	%
Allowance for Loan Losses			(12,781	)											(8,125	)
Net Loans			453,214				7,589				6.66	%			454,856				8,797				7.67	%
Loans Held for Sale			685				11				6.39	%			1,011				17				6.82	%
TOTAL EARNING ASSETS		$	545,317			$	8,408				6.13	%		$	564,033			$	9,898				6.96	%
Cash Due from Banks			15,284												17,075
All Other Assets			46,561												45,780
TOTAL ASSETS		$	594,381											$	618,763
LIABILITIES & SHAREHOLDERS’ EQUITY:
Deposits:
Interest bearing – DDA		$	96,763			$	302				1.24	%		$	99,379			$	602				2.40	%
Savings Deposits			87,291				182				0.83	%			89,030				307				1.37	%
Time CD’s $100,000 and Over			136,918				1,556				4.52	%			139,682				1,789				5.08	%
Other Time CD’s			115,122				1,069				3.69	%			124,739				1,449				4.61	%
Total Deposits			436,094				3,109				2.84	%			452,830				4,147				3.63	%
Other Borrowings			33,064				366				4.40	%			34,687				547				6.25	%
INTEREST BEARING LIABILITIES		$	469,158			$	3,475				2.95	%		$	487,517			$	4,694				3.82	%
Non-Interest bearing – DDA			75,892												75,648
All Other Liabilities			2,108												3,164
Shareholders’ Equity			47,223												52,434
TOTAL LIABILITIES & SHAREHOLDERS’ EQUITY		$	594,381											$	618,763
Net Interest Rate Spread											3.19	%											3.14	%
Net Interest Income /Margin						$	4,935				3.60	%						$	5,204				3.66	%

Allowance and Provision For Loan Losses

The Corporation maintains formal policies and procedures to control and monitor credit risk. Management believes the allowance for loan losses is adequate to provide for probable incurred losses in the loan portfolio. While the Corporation’s loan portfolio has no significant concentrations in any one industry or any exposure in foreign loans, the loan portfolio has a concentration connected with construction and land development loans. Specific strategies have been deployed to reduce the concentration level and limit exposure to this type of lending in the future. The Michigan economy, employment levels and other economic conditions in the Corporation’s local markets may have a significant impact on the level of credit losses. Management continues to identify and devote attention to credits that are not performing as agreed. Of course, deterioration of economic conditions could have an impact on the Corporation’s credit quality, which could impact the need for greater provision for loan losses and the level of the allowance for loan losses as a percentage of gross loans. Non-performing loans are discussed further in the section titled “Non-Performing Assets.”

The allowance for loan losses reflects management’s judgment as to the level considered appropriate to absorb probable losses in the loan portfolio. The Corporation’s methodology in determining the adequacy of the allowance is based on ongoing quarterly assessments and relies on several key elements, which include specific allowances for identified problem loans and a formula-based risk-allocated allowance for the remainder of the portfolio. This includes a review of individual loans, size, and composition of the loan portfolio, historical loss experience, current economic conditions, financial condition of borrowers, the level and composition of non-performing loans, portfolio trends, estimated net charge-offs and other pertinent factors. While we consider the allowance for loan losses to be adequate based on information currently available, future adjustments to the allowance may be necessary due to changes in economic conditions, delinquencies, or loss rates. Although portions of the allowance have been allocated to various portfolio segments, the allowance is general in nature and is available for the portfolio in its entirety. At September 30, 2008, the allowance was $11,342,000, or 2.47% of total loans compared to $8,554,000, or 1.81%, at December 31, 2007, reflecting an increase in the allowance $2,778,000 during the first nine months of 2008. Non-performing loan levels, discussed later, increased during the period and net charge-offs increased by $2,172,000 during the third quarter of 2008 compared to $893,000 during the third quarter of 2007. Management believes that the allowance is appropriate given the identified risk in the loan portfolio and based on asset quality.

Table 4 below summarizes loan losses and recoveries for the first nine months of 2008 and 2007. During the first nine months of 2008, the Corporation experienced net charge-offs of $2,840,000 or ..62% of gross loans compared with net charge-offs of $1,499,000 or .32% of gross loans in the first nine months of 2007. The provision for loan losses was $5,628,000 in the first nine months of 2008 and $6,232,000 for the same time period in 2007. During the third quarter of 2008, the provision for loan losses was $736,000 compared to $5,144,000 in the third quarter of 2007. The Corporation continues to provide a substantial amount to the provision for loan losses. Of the provided amount during the third quarter of 2008, $859,819 can directly be attributed to collateral valuation declines of twenty-one particular loans which were reviewed during the third quarter. Management review during the third quarter 2008 concluded that the Banks must provide additional specific reserves for those accounts. A sizeable portion of the 2008 year-to-date provision for loan losses was required for specific reserves calculated for non-performing construction and land development loans and the continuing impact of the decline in the Michigan economy.

Table 4 Analysis of the Allowance for Loan Losses

		Nine Months Ended September 30,
(000’s omitted)		2008				2007
Balance at Beginning of Period		$	8,554			$	6,692
Charge-Offs:
Commercial, Financial and Agriculture			(2,769	)			(1,189	)
Real Estate-Mortgage			(230	)			(105	)
Installment Loans to Individuals			(303	)			(409	)
Total Charge-Offs			(3,302	)			(1,703	)
Recoveries:
Commercial, Financial and Agriculture			266				129
Real Estate-Mortgage			0				1
Installment Loans to Individuals			196				74
Total Recoveries			462				204
Net Charge-Offs			(2,840	)			(1,499	)
Provision for loan losses			5,628				6,232
Balance at End of Period		$	11,342			$	11,425
Ratio of Net Charge-Offs to Gross Loans			0.62	%			0.32	%

Non-Interest Income

Non-interest income decreased during the nine months ended September 30, 2008 as compared to the same period in 2007, primarily due to the increase in loss on sale of real estate owned, increase in loss on sale of fixed assets, and decreases in service charges on deposits. Overall non-interest income was $4,602,000 for the nine months ended September 30, 2008 compared to $5,863,000 for the same period in 2007. This represents a decrease of 21.5%.

Non-interest income decreased in the third quarter of 2008 when compared to the same period in 2007. The most notable components of this decrease were the decrease in total service charges, decrease in official check commission, decrease in other income, increased loss on the sale of real estate owned, a reduced loss on the sale of fixed assets, decrease in building rental income and decrease in gain on sale of loans into the secondary market. In addition to these items, the bank recognized through equity accounting a third quarter 2008 loss of $239,000, pre-tax, on a DeNovo bank investment. This is an increase of $134,000 over third quarter 2007, as the Corporation held the investment for only one month in the third quarter of 2007. Overall non-interest income was $1,345,000 for the third quarter of 2008 compared to $1,970,000 for the same period in 2007. This was a decrease of 31.7%.

The most significant category of non-interest income is service charges on deposit accounts. These fees were $2,291,000 in the first nine months of 2008, compared to $2,547,000 for the same period of 2007. This represents a decrease of 10.1% from year to year. The decrease was attributable to lower customer usage of the overdraft privilege product, as customers continue to be more economically conscious. Customers also continued to migrate into the free checking products, which reduced related service charges. Debit Card income was up $21,000 year-to-year, remote customer capture charges were up $5,600, ATM Surcharges were down $24,000, Customer Service Fees were down $14,000, and other service charge categories remained relatively flat from year to year. Comparing service charges for the third quarter of 2008 to the third quarter of 2007 yielded a $58,000 decrease. The largest decrease was in NSF charges, which decreased $45,000 or 6.6%. Other service charges had minor decreases when comparing the third quarter of 2008 to the same time period in 2007.

The gain on the sale of mortgage loans originated by the Banks and sold into the secondary market decreased 3.0% to $260,000 for the nine months ended September 30, 2008 compared to $268,000 in the same period in 2007. This decrease was a result of uncertainty in the market. Rates were volatile during the quarter as credit requirements tightened up. The changes in credit requirements began to disqualify

borrowers whom may have qualified under different economic conditions. The gain on the sale of mortgages was down 35.4% when comparing the third quarter of 2008 to 2007. This decrease was equal to approximately $23,000.

Trust, investment and financial planning services income decreased slightly by $7,000 or 0.5% in the first nine months of 2008 compared to the same period in the prior year. The decrease was mostly due to a decrease in trust custodial fees. Comparing the third quarter of 2008 to 2007, trust, investment and financial planning services income decreased $13,000 or 2.8%. Total financial planning assets under management at September 30, 2008 were $132,407,000. Total market value of trust assets at September 30, 2008 was $135,895,000.

Other operating income decreased by $990,000 or 61.5% to $619,000 in the first nine months of 2008 compared to $1,609,000 in the same time period in 2007. The largest portion of the decrease is the loss on equity investment. In 2007, the Corporation acquired 24.99% of Valley Capital Bank headquartered in Mesa, Arizona. As a DeNovo bank, Valley Capital Bank was expected to have operating losses during their start-up phase. Accordingly, the Corporation has recognized its pro-rata ownership share of the operating loss. Using the equity method of accounting on this investment, the Corporation has experienced a loss of $696,000, pre-tax, on this startup DeNovo bank, as expected, in the first nine months of 2008. Of this loss, the Corporation has recognized $239,000, pre-tax, during the third quarter of 2008.

Categories of other operating income which had significant declines from year-to-year were: ATM surcharge income, official check commission, miscellaneous other income, loss on sale of fixed assets, loss on sale of real estate owned and building rental income. These decreases totaled $1,250,000 from year-to-year. Building rental income decreased $112,000 year to year due to one time income of a lease buy out in 2007 of $100,000 and the sale of rental property in one of the Banks. The loss on the sale of fixed assets increased comparing year-to-year by $129,000 and the loss on the sale of real estate owned increased $88,000 comparing year-to-year. The increase in these losses had a negative impact to income. Accounts with improvement from year-to-year were debit card income, income from servicing other institutions, loan placement fees and land contract income, totaling $116,000.

When comparing the third quarter of 2008 to the third quarter of 2007, categories of other operating income had notable decreases in official check commission, gain on sale of fixed assets, building rental income, gain on sale of loans into the secondary market, and miscellaneous other income. Official check commission decreased $34,000, gain on sale of fixed assets decreased $11,000, building rental income decreased $22,000 due to the sale of a rental property, gain on sale of loans into the secondary market decreased $24,000. The decrease in miscellaneous other income was due to equity accounting on a DeNovo investment, which totaled $239,000 for the quarter. When comparing the third quarter of 2008 to the third quarter of 2007, losses on the sale of real estate owned increased by $14,000.

Non-Interest Expense

Total non-interest expense increased 2.8% to $16,783,000 in the nine months ended September 30, 2008, compared with $16,330,000 in the same period of 2007. Occupancy expenses, loan and collection expenses and other operating expenses increased year-to-year. The increase was partially offset by a decrease in salaries and benefits and furniture and equipment. The Corporation has also recognized year-to-date other-than-temporary impairment of $843,000 on a DeNovo bank investment. Comparing the third quarter of 2008 to 2007, non-interest expenses had a modest decrease of 0.3% or $18,000.

Salary and benefit costs, the Corporation’s largest non-interest expense category, were $8,620,000 in the first nine months of 2008, compared with $9,308,000, or a decrease of 7.4%, for the same time period in 2007. The decrease of about $688,000 was due to staff reduction actions and the elimination of performance bonus payments. Salary and benefit costs also decreased when comparing third quarter 2008

to 2007. The decrease of $185,000 or 6.5% were also a result of reduction through resignation or attrition. As the economy has weakened, management strategically modified staffing levels for efficiency and effectiveness.

Occupancy expenses, at $1,574,000, increased slightly in the nine months ended September 30, 2008 compared to the same period in 2008 by $18,000 or 1.2%. Year-to-date increases in building repairs and maintenance, utilities, property taxes and building depreciation, are partially attributable to the opening of a new office in early 2008. Year-to-date decreases in property insurance and occupancy costs associated with leased facilities largely offset the increases. Occupancy expenses decreased $51,000 or 9.4% when comparing the third quarter of 2008 to 2007. This was due to decreases on building repairs and maintenance, adjusted accruals on property taxes and decreases in leased facilities with the closure of two branch offices.

During the nine months ended September, 30, 2008, furniture and equipment expenses were $1,508,000 compared to $1,591,000 for the same period in 2007, a decrease of 5.2%. The decreases in expenses were a result of declines in depreciation expense as assets reach their useful lives and become fully depreciated, decreases in rental expense with the transfer to an internet based telephone system and decreases in maintenance contracts. Management continues to scrutinize expenses related to service providing vendors, ensuring that necessary services are being performed and to identify opportunities to improve. Furniture and equipment expenses decreased $54,000 or 10.2% when comparing the third quarter of 2008 to the third quarter of 2007. The largest decreases were in furniture and equipment depreciation and in depreciation on the mainframe computer system, which fully depreciated at the end of the second quarter 2008.

Loan and collection expenses, at $718,000, were up $431,000 or 150.2% during first nine months of 2008 compared to the same time period in 2007. The increase was primarily attributable to the valuation adjustment of other real estate owned property, which totaled $145,000. Also, an increase in collection expenses and other loan expense relating to other real estate owned were contributors to the increase. The rise in these expenses was a result of the unfavorable economy in Michigan and the related loan workout activities. As the level of these accounts increase, we anticipate these expenses to be above desired levels until the economic situation begins to become more favorable. When comparing the third quarter of 2008 to 2007, an increase of $62,000 or 55.9% was experienced by the Corporation, again as a result of the unfavorable changes to the Michigan economy.

Advertising expenses of $363,000 in the nine months ended September 30, 2008 decreased 8.3% compared with $396,000 for the same period in 2007. While maintaining market presence, the Corporation was able to reduce advertising expense. The Corporation continues to remain focused on targeted advertising in all of its markets in an attempt to achieve continued growth. Advertising expenses decreased $11,000 or 8.8% when comparing the third quarter of 2008 to the third quarter of 2007.

In the third quarter of 2008, the Corporation recorded a $233,000 charge to other non-interest expense due to the other-than-temporary impairment of a DeNovo bank investment as of September 30, 2008. Year-to-date, the Corporation has recorded an $843,200 charge to other non-interest expense and has now fully written off this investment. This action was taken as a result of notification received of the cessation of operations of this institution.

Other operating expenses were $3,157,000 in the nine months ended September 30, 2008 compared to $3,192,000 in the same time period in 2007, a decrease of $35,000 or 1.1%. Reduced expenses of telephone and communication, postage, audit fee expenses, director compensation, business development expense, conference and education, customer service expense and losses on overdraft privilege were largely offset by increases in other categories. Expenses that had notable increases were legal expense, FDIC assessment expense, and a miscellaneous loss, of approximately $51,000, on the buy back of a mortgage. Other operating expenses had a decrease of $12,000 or 1.1% when comparing the third quarter

of 2008 to 2007. The Corporation had a federal income tax benefit totaling $71,000 during the quarter. This benefit arose as a result of the recognition of the other-than-temporary impairment on the DeNovo bank, which allowed for a tax benefit of $79,000.

Financial Condition

Proper management of the volume and composition of the Corporation’s earning assets and funding sources is essential for ensuring strong and consistent earnings performance, maintaining adequate liquidity and limiting exposure to risks caused by changing market conditions. The Corporation’s securities portfolio is structured to provide a source of liquidity through maturities and to generate an income stream with relatively low levels of principal risk. The Corporation does not engage in securities trading. Loans comprise the largest component of earning assets and are the Corporation’s highest yielding assets. Customer deposits are the primary source of funding for earning assets while short-term debt and other sources of funds are also utilized when market conditions and liquidity needs change.

The Corporation’s total assets were $587 million at September 30, 2008 compared to total assets of $628 million at December 31, 2007. The decrease in total assets was due to a reduction in the security portfolio of $17.5 million, a loan portfolio decrease of $12.6 million and the reduction of federal funds sold of $1.7 million since December 31, 2007. Loans comprised 78.1% of total assets at September 30, 2008 compared to 75.1% at December 31, 2007. Loans decreased $6.1 million during the third quarter of 2008. During the third quarter of 2008, other assets increased $5,338,000. This increase was partially due to the transfer of $6,520,000 of loans into other real estate owned. On the liability side of the balance sheet, the ratio of non-interest bearing deposits to total deposits was 14.5% at September 30, 2008 and 13.8% at December 31, 2007. Interest bearing deposit liabilities totaled $434.3 million at September 30, 2008 compared to $468.4 million at December 31, 2007. Total deposits decreased $35.4 million with non-interest bearing demand deposits decreasing $1,281,000 and interest bearing deposits decreasing $34,098,000. Short-term borrowings increased $1,726,000 due to the decrease in deposits, comparing the two periods. FHLB advances increased $3,977,000 comparing the two periods. Repurchase agreement balances decreased comparing the two periods. Repurchase agreements are instruments with deposit type characteristics, which are secured by government securities.

Bank premises and equipment decreased $1,095,000 to $19.0 million at September 30, 2008 compared to $20.1 million at December 31, 2007. The decrease was due to the sale of a bank owned rental property during the first quarter of 2008, the disposal of check processing equipment in the second quarter of 2008 and continued standard depreciation of bank premises and equipment.

Non-Performing Assets

Non-performing assets include loans on which interest accruals have ceased, loans past due 90 days or more and still accruing, loans that have been renegotiated, and real estate acquired through foreclosure. Table 5 reflects the levels of these assets at September 30, 2008 and December 31, 2007.

Non-performing assets increased substantially from December 31, 2007 to September 30, 2008. The increase of $12,678,000 was primarily due to increases in loans past due 90 days or more and still accruing, non-accrual loans and an increase in other real estate. Loans past due 90 days or more and still accruing increased $3,822,000 and non-accrual loans increased $3,184,000. The REO-in-Redemption balance of $888,000 is comprised of one commercial property and eleven residential properties at September 30, 2008. Marketability of these properties is dependent on the local real estate market. Renegotiated loans increased $2,571,000 from December 31, 2007 to a total of $3,002,000 at September 30, 2008. Additionally, $6,917,000 of loans have transferred into other real estate since December 31, 2007. Of these loans transferred into other real estate, the Corporation has recognized $159,000 in additional negative valuation adjustments on these properties and has sold $2,782,000 of these properties.

The level and composition of non-performing assets is affected by economic conditions in the Corporation’s local markets. Non-performing assets, charge-offs, and provisions for loan losses tend to decline in a strong economy and increase in a weak economy, potentially impacting the Corporation’s operating results. In addition to non-performing loans, management carefully monitors other credits that are current in terms of principal and interest payments but, in management’s opinion, may deteriorate in quality if economic conditions change. As of September 30, 2008, 64.0% of non-accrual loans were land development loans. The remaining 36.0% of non-accrual loans are varied in their purpose and include manufacturers, individuals and other businesses. Of the non-performing loans, seven loans with principal balances totaling $560,000 were placed on a non-accrual status during the third quarter. This resulted in a third quarter 2008 loss of interest income of $18,700 and a year-to-date 2008 loss of interest income of $498,750.

Certain portions of the Corporation’s non-performing loans included in Table 5 are considered impaired. The Corporation measures impairment on all large balance non-accrual commercial loans. Certain large balance accruing loans rated watch or lower are also measured for impairment. Impairment risk is believed to be adequately covered by the allowance for loan losses.

The Corporation maintains policies and procedures to identify and monitor non-accrual loans. A loan is placed on non-accrual status when there is doubt regarding collection of principal or interest, or when principal or interest is past due 90 days or more. Interest accrued but not collected is reversed against income for the current quarter, when the loan is placed in non-accrual status.

Table 5 Non-Performing Assets and Past Due Loans

		September 30,				December 31,
		2008				2007
Non-Performing Loans:
Loans Past Due 90 Days or More & Still Accruing		$	3,876			$	54
Non-Accrual Loans			16,240				13,056
Renegotiated Loans			3,002				431
Total Non-Performing Loans			23,118				13,541
Other Non-Performing Assets:
Other Real Estate			5,978				2,003
REO in Redemption			888				1,829
Other Non-Performing Assets			222				155
Total Other Non-Performing Assets			7,088				3,987
Total Non-Performing Assets		$	30,206			$	17,528
Non-Performing Loans as a % of Total Loans			5.02	%			2.86	%
Allowance for Loan Losses as a % of Non-Performing Loans			49.06	%			63.18	%
Accruing Loans Past Due 90 Days or More to Total Loans			0.84	%			0.01	%
Non-performing Assets as a % of Total Assets			5.14	%			2.79	%

Liquidity and Interest Rate Risk Management

Asset/Liability management is designed to assure liquidity and reduce interest rate risks. The goal in managing interest rate risk is to maintain a strong and relatively stable net interest margin. It is the responsibility of the Asset/Liability Management Committee (ALCO) to set policy guidelines and to establish short-term and long-term strategies with respect to interest rate exposure and liquidity. The ALCO, which is comprised of key members of management, meets regularly to review financial performance and soundness, including interest rate risk and liquidity exposure in relation to present and

prospective markets, business conditions, and product lines. Accordingly, the committee adopts funding and balance sheet management strategies that are intended to maintain earnings, liquidity, and growth rates consistent with policy and prudent business standards.

Liquidity maintenance together with a solid capital base and strong earnings performance are key objectives of the Corporation. The Corporation’s liquidity is derived from a strong deposit base comprised of individual and business deposits. Deposit accounts of customers in the mature market represent a substantial portion of deposits of individuals. The Banks’ deposit base plus other funding sources (federal funds purchased, short-term borrowings, FHLB advances, repurchase agreements, fed discount window, other liabilities and shareholders’ equity) provided primarily all funding needs in the first nine months of 2008. While these sources of funds are expected to continue to be available to provide funds in the future, the mix and availability of funds will depend upon future economic conditions. The Corporation does not foresee any difficulty in meeting its funding requirements.

Primary liquidity is provided through short-term investments or borrowings (including federal funds sold and purchased) while the securities portfolio provides secondary liquidity. The securities portfolio has decreased $17.5 million since December 31, 2007 due to the calls and maturities of securities and pay downs of Mortgage Backed Securities (MBS) and the recording of other-than-temporary impairment of a security. The Corporation has decided to invest the excess funds, from the call of these securities, in the securities and loan portfolios to increase yield and income versus keeping the excess funds in federal funds sold at a lower yield. The Corporation regularly monitors liquidity to ensure adequate cash flows to cover unanticipated reductions in the availability of funding sources.

The Corporation’s consolidated securities portfolio is managed to minimize interest rate risk, maintain sufficient liquidity and maximize return. Securities fair market value has decreased $636,000 from June 30, 2008. The total securities portfolio decreased $17,457,000 from December 31, 2007. The decline from December 31, 2007 to September 30, 2008 was partially due to calls on securities totaling approximately $12,662,000, of which $7,817,000 was reinvested in securities. An additional $843,200 decrease was due to the other-than-temporary impairment write off of an investment of a DeNovo bank. Management believes that the decline in fair market value was attributable to interest rate factors, general market risk re-pricing, and lack of liquidity in the capital markets versus underlying collateral or credit quality issues of a particular investment. As such, we do not believe any remaining individual unrealized losses as of September 30, 2008 represent other-than-temporary impairment, as no holdings have been downgraded below investment grade by any of the rating agencies. We have no knowledge that any of our direct investments consists of sub prime loans. We continue to review the cash flow projections on all of our mortgage backed securities. Based on this analysis and our review, these instruments have cash flows sufficient to cover any scheduled principal and interest payments. The Corporation has both the intent and the ability to hold each of the securities for the time necessary to recover its amortized cost.

Interest rate risk is managed by controlling and limiting the level of earnings volatility arising from rate movements. The Corporation regularly performs reviews and analysis of those factors impacting interest rate risk. Factors include maturity and re-pricing frequency of balance sheet components, impact of rate changes on interest margin and prepayment speeds, market value impacts of rate changes, and other issues. Both actual and projected performance are reviewed, analyzed, and compared to policy and objectives to assure present and future financial viability.

The Corporation had cash flows from financing activities resulting primarily from the decrease of demand and savings deposits. In the first nine months of 2008, these deposits decreased $35,379,000. Cash provided by investing activities was $17,900,000 in first nine months of 2008 compared to cash used of $6,764,000 in first nine months of 2007. The change in investing activities was due to the calls on available for sale securities totaling $12,662,000, the maturity of $7,441,000 of available for sale securities and sales of available for sale securities of $1,999,000. Held to maturity securities also had maturities of $1,332,000. Proceeds from maturities and calls of securities, were partially reinvested in available for sale securities of $7,067,000 and held to maturity securities of $750,000. A portion of the remaining difference was used to offset declines in deposit balances.

Capital Management

Total shareholders’ equity decreased 6.7% to $46,201,000 at September 30, 2008 compared with $49,496,000 at December 31, 2007. The Corporation’s equity to asset ratio was 7.87% at September 30, 2008 and 7.88% at December 31, 2007. The decrease of the ratio was due to a greater decline in shareholder equity than the decline in assets.

As indicated on the balance sheet at December 31, 2007, the Corporation had an accumulated other comprehensive loss of $470,000 compared to accumulated other comprehensive loss at September 30, 2008 of $1,524,000. The increase in the loss position is attributable to the fluctuation of the market price of securities held in the available for sale portfolio.

The Corporation has indefinitely suspended payment of dividends until the financial performance of the Corporation improves.

Regulatory Capital Requirements

Bank holding companies and their bank subsidiaries are required by banking industry regulators to maintain certain levels of capital. These are expressed in the form of certain ratios. These ratios are based on the degree of credit risk in the Corporation’s assets. All assets and off-balance sheet items such as outstanding loan commitments are assigned risk factors to create an overall risk-weighted asset total. Capital is separated into two levels, Tier I capital (essentially total common shareholders’ equity plus qualifying cumulative preferred securities (limited to 33% of common equity), less goodwill) and Tier II capital (essentially the allowance for loan losses limited to 1.25% of gross risk-weighted assets). Capital levels are then measured as a percentage of total risk weighted assets. The regulatory minimum for Tier I capital to risk weighted assets is 4% and the minimum for Total capital (Tier I plus Tier II) to risk weighted assets is 8%. The Tier I leverage ratio measures Tier I capital to average assets and must be a minimum of 3%. As reflected in Table 6, at September 30, 2008 and at December 31, 2007, the Corporation was well in excess of the minimum capital and leverage requirements necessary to be considered a “well capitalized” banking company.

The FDIC has adopted a risk-based insurance premium system based in part on a bank’s capital adequacy. Under this system, a depository institution is classified as well capitalized, adequately capitalized, or undercapitalized according to its regulatory capital levels. Subsequently, a financial institution’s premium levels are based on these classifications and its regulatory supervisory rating (the higher the classification the lower the premium). It is the Corporation’s goal to maintain capital levels sufficient to retain a designation of “well capitalized.”

Table 6

		Capital Ratios
						Fentura Financial, Inc.
		Regulatory Minimum				September 30				December 31,				September 30,
		For “Well Capitalized”				2008				2007				2007
Total Capital to risk
Weighted assets			10	%			11.66	%			11.60	%			11.77	%
Tier 1 Capital to risk
Weighted assets			6	%			10.41	%			10.40	%			10.53	%
Tier 1 Capital to average
Assets			5	%			9.12	%			9.00	%			8.38	%