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Executives

Benjamin A. Smith III - Chairman

Philip J. Koning – President, Chief Executive Officer

Ronald L. Haan – Executive Vice President

Jon W. Swets – Senior Vice President, Chief Financial Officer

Analysts

Stephen Geyen – Stifel Nicolaus & Company, Inc.

Terry McEvoy – Oppenheimer & Co.

Jason Werner – Howe Barnes Investments

Eric J. Grubelich, CFA – Keefe, Bruyette & Woods

Macatawa Bank Corporation (MCBC) Q4 2007 Earnings Call January 15, 2008 10:00 AM ET

Operator

Good morning. My name is Nicole and I will be your conference operator today. At this time I would like to welcome everyone to the Macatawa Bank Corporation’s fourth quarter earnings release conference call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks there will be a question and answer session. If you would like to ask a question during this time simply press * and the number one on your telephone pad.

Thank you, Mr. Smith, you may begin your conference.

Benjamin A. Smith III

Thank you, Nicole. Good morning, everyone. My name is Ben Smith and I’m chairman and CEO of Macatawa Bank Corporation. We’re happy that you could join us for our fourth quarter 2007 earnings report conference call. Joining us this morning are Philip Koning, President and CEO of Macatawa Bank, Ron Haan, Executive Vice President, and Jon Swets, CFO. Each of these people will make some brief remarks then we’ll take questions from the participants. So let’s begin with some remarks from Jon.

Jon W. Swets

Thank you, Ben. I’m going to walk you through just a few areas of our financial performance for the quarter starting with net interest margins. So we’ll just get right into the topics at hand for the day.

Fourth quarter results reflect the provision for loan losses entry that we announced about a month ago. An additional $9.5 million in provision for loan losses was announced. That created a net loss for the quarter in the amount of $2.8 million, as reported. But as I say, I’m going to jump right into a couple of topics just to make sure that they’re understood sufficiently.

Net interest margin was 3% during the fourth quarter of 2007. That’s a 20 basis point decline on a consecutive-quarter basis and I thought it would be relevant to make sure we talk through why the 20 basis point decline on a consecutive-quarter basis.

As in all previous quarters throughout ’07, really yield on assets was the primary cause for net interest margin decline. During the fourth quarter we did see a reduction in our cost of funds. It was down 16 basis points. However, our yield on assets was down 34 basis points. So certainly far more than the (inaudible).

There are several components to that decline in yield on assets of 34 basis points. One of the more significant components of this decline was the higher average of non-performing assets in the fourth quarter. The average of non-performing assets, the average principle balance of non-performing assets increased by $25 million when you compare fourth quarter to third quarter. That alone creates about a 10 basis point decline in net interest margin.

Also, write offs on loans and write off of interest on loans as we moved those loans into non-accrual status was greater in the fourth quarter than in the third quarter and the amount that it was greater caused another 6 basis points in decline in the yield on assets net interest margin. So those two things really relate to the growth in the non-performing asset to add up to about 16 basis points of the 34.

So what that really means is, outside of that, our yield on assets decreased by 18 basis points. So an 18 basis point decline in yield on assets compared to a 16 basis point decline in cost of funds netted about a 2 to 3 basis point decline in true core net interest margin. So really, the margin faired quite well relative to the fed funds rate cut; certainly in that time frame beginning in late September. So late third quarter the feds started cutting rates and they’re down 100 basis points. So at the same time of 100 basis point decline in feds fund rates our true core margin down 2 to 3 basis points.

Moving on to non-interest expense. The total of non-interest expense increased by 17% versus the fourth quarter of the prior year. On a linked-quarter basis it was up 3%. But I thought I should touch on some of the components of that 17% increase, beginning with occupancy and furniture fixtures and equipment expense. Really, the primary reason for the increase we’re seeing in those categories is what I’ve touched on in prior quarterly conference calls. We put up four new buildings. Two new branches and then two other branches we relocated, but to two new buildings. So really four new structures throughout 2007. That’s really at the heart of why the occupancy and equipment expense is up compared to the fourth quarter of the prior year.

A couple of other major components of that increase include again, pressure from working through disposition of problem assets. Categories of expenses that are impacted by that activity include legal expense, expenses associated with holding repossessed and foreclosed assets, there are other unrealized losses that we take in the process of holding repossessed assets, and then other appraisal expenses, various kinds of things. All of those things were higher than the fourth quarter of ’06 by just about $350,000. So we did have, of course, with our higher level of non-performing assets, additional expenses there that amounted to about 350.

And then of course the other major component of the increase, as I’ve mentioned in previous conference calls, relates to the additional FDIC insurance. For us, because of our young age, we don’t get any rebates, so the change in rate on FDIC insurance impacted us entirely to the negative. And the difference between FDIC insurance fourth quarter last year to fourth quarter this year is about $235,000. So those are really the more major components of the difference in other expense between last year and this year fourth quarters.

Just want to touch on a couple of balance sheet items. To begin with, our loan portfolio for both the quarter and the full year we did see some growth for the quarter. Growth in the loan portfolio was right around $14 million for the year. About $39 million. Most of that growth for both the quarter and the full year came in consumer mortgages.

Our commercial portfolio was relatively flat for the quarter, slightly up for the year. And then our instalment loans, just basic consumer loans for the year were relatively stable, and for the quarter.

AS far as the deposit portfolio is concerned, our core deposits on the funding side of our balance sheet, I know Phil will touch on what’s really taking place on the funding side of our balance sheet a little more, so I’ll let his comments cover those activities.

Then I thought I would just close in talking briefly about non-performing loans. Of course there was an increase in the fourth quarter in our non-performing assets, up to $79.8 million, most of which were non-performing loans at $73.9 million. That’s up about $45 million from the end of the third quarter, $25.2 million increase.

Of that $25 million, $23 million was in loans to residential developers. So as we talked about in our third quarter earnings conference call and in the press release in 8K that we issued about a month ago addressing our additional provision for loan losses, really all of this stress is coming from or primarily from our loans to residential developers.

Of the roughly $74 million in non-performing loans, $68.6 million is in commercial real estate and then, out of that $68.6 million, $57.4 million is in loans to residential developers.

And now I’ll turn it over to Ron Haan, who will give a small background on loans and asset quality.

Ronald L. Haan

Thanks, Jon. As Jon indicated, this has been a difficult quarter and a challenging year. We did see modest loan growth, but clearly asset quality continues to receive a lot of attention around here. Asset quality continues to show signs of deterioration during the quarter in both non-performing loans and past-due trends.

Consistent with our previous communications, most of our problems are related to residential land development loans. We are seeing limited lot sales in the market and a corresponding reduction in our exposure, but the trend has been gradual and will need to see an acceleration in sales before these loans return to performing status.

Generally there continues to be widespread weakness throughout this sector and we have responded by moving loans that display any material cash flow or collateral weakness into non-performing status. We are confident that we have identified our potentially troubled loans and we are managing these risks effectively. We do feel that our current reserves, along with the increased provision recorded during the fourth quarter, should be adequate based on what we see today.

While much has been written about banks limiting access to credit, we are clearly open for business and remain confident with our ability to grow during difficult economic times. Despite high employment and the challenging real estate market, there are many companies in Western Michigan that continue to do well and we have accelerated our business development efforts targeting those companies.

Looking forward in 2008 we are hopeful that the forecast of lower interest rates along with job growth will help stabilize the real estate markets and increase the velocity of land sales. As the real estate markets in Western Michigan stabilize we should see more normal operating performance.

With that I’ll turn it over to Phil.

Philip J. Koning

Thank you, Ron. I would just like to take a few minutes to talk about the funding side of our business and the West Michigan economy. Relative to growing our deposit base, 2007 was slower than previous years. However, we still did have relatively good growth in new relationships and core deposits. We opened more than 2,500 net new demand deposit relationships during the past year with core relationship deposits increasing about $70 million. Continued increase in market share, especially in the Grand Rapids area, should help us continue to grow our deposit base.

You can see from our financial statements that total deposits fell by $144 million from year-end 2006 to year-end 2007. However, broker deposits and the one large deposit relationship we have mentioned in earlier calls decreased by $216 million, therefore giving us growth of slightly more than $70 million across the broader deposit base. We chose to fund these decreases and total deposits with both federal home loan bank advances and repo agreements.

Relative to the West Michigan economy, its performance during 2007 has been relatively flat. Our unemployment rate remains near 6%. As you have heard earlier, this lack of growth has particularly affected the residential development area with rising inventories of unsold homes and lots and lower valuations. That being said, West Michigan continues to transition and diversify its economic base and has fared better than the rest of our state.

A recent study from the Upjohn Institute underscored some bright spots for our community. After relatively flat job growth in 2007, a leading economist from Upjohn anticipates modest employment growth in the Hollands and Grand Rapids area – two of our key markets for 2008. Health care, biotech, education, and related services have been growing and that growth is expected to continue.

While manufacturing jobs may continue to decline at large companies, smaller and more entrepreneurial businesses are coming into the region, which remains attractive because of our highly skilled workforce, reasonable labour rates, competitive cost structure, and available commercial space. We have also been able to attract out-of-state investors to invest in the West Michigan area; a trend we expect to continue in 2008.

Once Michigan economic development agencies have laid out many initiatives that are gaining traction. Our communities have always responded to difficult times with a positive can-do attitude by gaining efficiencies, entering new markets, and developing new products and services.

As we increase the number of jobs our population will grow along with the economic activity that will help drive deposit growth, loan growth, consumer confidence and, in turn, the housing market. While we are still challenged by the current economic environment and see no quick or dramatic improvement we have confidence that West Michigan will once again experience growth and economic prosperity.

I’ll turn it back to you, Ben.

Benjamin A. Smith III

All right. Thank you very much. As you all can appreciate, this has been a very difficult quarter and a very difficult year for Macatawa Bank, as it has for many other financial institutions. At Macatawa one thing we’ve always taken great pride about is having a clear and complete disclosure as much as we really can with our shareholders. Because of everything that’s going on today and because of the fast movement of some of these issues, it remains very difficult to provide that information on a day-to-day basis.

So a meeting like this, while sometimes is not very comfortable for us, it is very helpful for us so that you can provide as clear information as you can to our shareholder base who we think deserves to know everything that we know and everything that we’re thinking about at this point in time.

So with that in mind, what we’ll do is we’ll throw it open at this time for questions from the floor. Nicole?

Question-and-Answer Session

Operator

Yes, Sir. (Operator Instructions). Your first question comes from the line of Stephen Geyen.

Stephen Geyen – Stifel Nicolaus & Company, Inc.

Yes, good morning. I was just wondering, has there been a noticeable migration in the rating of loans that are not much listed as performing? Are those rated one to six?

Philip J. Koning

No, really the biggest migration has occurred in our downgrades of residential land development loans. You know, of that $74 million roughly $55 million of that is past due today $20 million or 25% would be performing.

But you know, the other portfolios really are holding up pretty well. So the trends in the increase of non-performing and the increase in past dues are pretty much limited to that residential land development sector.

Stephen Geyen – Stifel Nicolaus & Company, Inc.

Okay. So it sounds like the increase in the provision this quarter is more from the allocated portion rather than the plu (sic) portion.

Philip J. Koning

Yes. Yes. Exactly.

Stephen Geyen – Stifel Nicolaus & Company, Inc.

Okay. Do the residential construction (inaudible) still performing generate enough cash flow for projects that meet the terms and loans or some of the borrowers had to tap some of their liquidity or other income to carry the projects?

Philip J. Koning

Well, clearly some borrowers have had to tap their liquidity. The sector that’s probably experienced the most stress would be loans that have been developed, but they’re what I call lot sales. In other words, construction of the home has not begun yet and it’s vacant but improved land. That’s the area that we’re seeing the greatest slow down and the greatest stress.

Stephen Geyen – Stifel Nicolaus & Company, Inc.

And would all those be non-performing or considered impaired? You know, in that situation that they are tapping other income or liquidity.

Philip J. Koning

Actually, we’ve gone through all of those loans very carefully and those that we feel potentially face cash flow problems or may have a material weakness in terms of collateral, those are the loans that we’ve moved to non-performing. Again, some of those loans, roughly $20 million, do continue to perform today, but we’ve moved them to non-performing status because of the weakness we see in that sector.

Stephen Geyen – Stifel Nicolaus & Company, Inc.

Okay. And one last question. Regarding other expense next year, once loans become non-performing are the legal fees and carrying costs pretty much front-end loaded or are there some additional costs that kind of continue on?

Philip J. Koning

There are definitely additional costs that do continue on.

Stephen Geyen – Stifel Nicolaus & Company, Inc.

And how much are we looking at, at those loans that have been added to the watch list of non-performing, how should we look at that next year as far as their contribution to the other expense?

Philip J. Koning

That’s really hard to determine, Stephen. It’s so dependent on the individual credit and its circumstances and how much workout effort it takes, whether or not we need to involve legal assistance. Honestly, it’d be very difficult for me to predict.

Stephen Geyen – Stifel Nicolaus & Company, Inc.

Okay. Understand. Thanks.

Operator

Your next question comes from the line of Terry McEvoy.

Terry McEvoy – Oppenheimer & Co.

Good morning.

Philip J. Koning

Good morning, Terry.

Terry McEvoy – Oppenheimer & Co.

I was wondering if you could comment on the impact of the new Michigan business tax on Macatawa, which I believe went into effect January 1 of this year?

Philip J. Koning

Right. That tax is actually turning out to be a relatively mild tax, at least in our circumstances as we’ve evaluated the extent of our liability. It should be a relatively nominal liability. We’re estimating less than $150,000 on an annual basis.

Terry McEvoy – Oppenheimer & Co.

And then, in order to help us on this side of the discussion, so to speak, to come up with a better feel for quarter estimates and PA levels charge offs, which we’ve had a difficult job doing over the past couple of quarters, could you maybe help us with your assumptions on lot sales, lot sale volume, home prices? Just what’s baked into the current estimated value of MPAs. So we as analysts and investors can maybe track that up against what you’re using to again come up with a better job on trying to value your assets and potential losses in 2008.

Philip J. Koning

Well, I can speak to the residential development loans. Again, we’ve looked at all of those credits. Those that we feel have material weakness today, you know, we’ve moved to non-performing. That business hasn’t stopped dead in the water. We are seeing lot sales, albeit slow. And if you follow our numbers we have seen reduction in our exposure. So again, based on what we see today, I wouldn’t anticipate a lot more deterioration because of our exposure in that area. We’ve got a considerable amount that we’ve already moved to non-performing and we’ve set up a pretty significant reserve.

So forecasting the future is always difficult for us. Again, we’re hopeful that the forecast of lower interest rates and we are seeing forecasts now for some job growth in western Michigan that those factors will help stabilize the real estate market and if that happens then we should start to see some acceleration in these lot sales and return to what I would call a more normal operating environment.

Terry McEvoy – Oppenheimer & Co.

And then just a question away from the loans for the development or sale of one- to four-family properties. Just looking at commercial real estate, there’s about $11 million of MPAs not connected with that business. Can you talk about your outlook going into the year for the, again, the non-residential component of CRE and are you seeing higher delinquencies and internally do you see the MPAs in that business migrating upward as well as the losses?

Philip J. Koning

Really there’s a pretty strong correlation between the increase of non-performing and the past dues. It’s, I think we generally feel pretty good about the performance of the loans and other sectors. It’s really the residential land development that’s given us the most heartburn right now.

Terry McEvoy – Oppenheimer & Co.

Great. Thank you very much.

Operator

Again, if you would like to ask a question please press * and the number one on your telephone key pad. Your next question comes from the line of Jason Werner.

Jason Werner – Howe Barnes Investments

Good morning guys. Just to follow up on one of Terry’s questions about the land loans development. You guys broke out and released that component. I think it was a total of $235 million and you broke it out into three different categories, the largest of which is the developed land that is improved but still vacant with lot loans. How much of that $125.6 million is non-performing?

Philip J. Koning

Of the $125 million it’s $37 million.

Jason Werner – Howe Barnes Investments

And then of the other two components, the vacant land and the spec homes, how much is spec homes?

Philip J. Koning

Spec homes are about $17 million. What we’re finding though is we evaluate the spec homes, once things go vertical that portion of this category alone, loans to residential developers, the amount of specific reserves we’re having to set aside are far lower. The valuations are much stronger in that area than in just certainly the raw land and the improved land.

Jason Werner – Howe Barnes Investments

Okay. Can you give us a sense then of how much the reserves are for that developed lot, that $37 million that’s non-performing? How much is that reserve for?

Philip J. Koning

Well, I can say that we’ve got specific reserves on every one of those loans. But yeah, honestly, I guess I don’t have the detail you’re looking for for now.

Jason Werner – Howe Barnes Investments

Okay. What can you give us in terms of the sense of, what’s happening to valuations within that kind of category? Are we seeing 10% declines? Twenty? Thirty? What’s the market doing with the value of the land that’s been improved?

Philip J. Koning

You know, I would say generally, clearly we’ve seen a reduction in values. It’s probably arranged though. You know, it’s all location, location, location. The nicer projects may be 10%, 5% to 10% and some of the slower developments it could be more than that.

Jason Werner – Howe Barnes Investments

Okay. And then also I was kind of curious, the total construction and land development portfolio is $335 million. You said $235 million is the loans for development or sale of one- to four-family. What is that additional $100 million? What’s that (inaudible) for?

Philip J. Koning

It’s all different kinds of things. Honestly, we’ve got construction and land development loans in various, I guess, categories of commercial real estate, whether it be office building, retail centres, those kind of things.

Jason Werner – Howe Barnes Investments

Is that all, that whole $100 million on that net, that’s pretty much commercial? It’s not really, is there any component in there that’s residential?

Philip J. Koning

No, no, no. No, the $235 million was the number that really captures all of the residential related components of the $335 million.

Jason Werner – Howe Barnes Investments

Okay. And then I guess the, what, obviously you guys look at your portfolio and you say you think you’ve identified most of the problems. I guess what can you tell us to give us comfort that $125 million of these lot loans, $37 million of them are non-performing and there’s still a lot left there performing. How do we know that these things don’t continue to bleed over to non-performing as you go into ’08.

Philip J. Koning

I don’t know –

Ronald L. Haan

I don’t know that we can guarantee that. That would be our analysis today would suggest that the borrower has capacity to continue to pay or we’re seeing sufficient velocity of sales in those projects that the sales should be able to support their interest carried.

Jason Werner – Howe Barnes Investments

So the difference here is maybe you have a little stronger borrower or maybe a better location so you have more sales.

Ronald L. Haan

Yes.

Jason Werner – Howe Barnes Investments

Okay. Okay, then, I was wondering if you could quantify what past dues are. The 30- to 80-day bucket right now.

Philip J. Koning

Well, I know that our total past dues including 90 plus are right at about 5%. I don’t have the break down between the 90 plus and the 30 to 89. Sorry, Jason.

Jason Werner – Howe Barnes Investments

All right. Thank you very much, guys.

Operator

Your next question comes from the line of Eric Grubelich.

Eric J. Grubelich, CFA – Keefe, Bruyette & Woods

Hi, good morning. Can you hear me?

Philip J. Koning

Yes.

Eric J. Grubelich, CFA – Keefe, Bruyette & Woods

Hi, how are you? Good. Could you, Jon or maybe Ron, could you just round out a couple numbers for me? You had given I guess some of the breakdown of the MPAs by, I think the spec homes and it was $17 million, and I think you mentioned the developed land was $37 million. Did I hear that correctly?

Philip J. Koning

Yes.

Eric J. Grubelich, CFA – Keefe, Bruyette & Woods

Okay. So if I’m looking at the $68 million worth of commercial real estate and PLs, how much of that is actually related to the one before, excuse me, the residential land development portfolio? Is it almost all of it?

Jon W. Swets

Well, it’s that number I quoted earlier.

Eric J. Grubelich, CFA – Keefe, Bruyette & Woods

I may have missed that, Jon. I had to jump off. What was that?

Jon W. Swets

I’m sorry. It’s $57.4 million.

Eric J. Grubelich, CFA – Keefe, Bruyette & Woods

Oh, okay. Okay.

Jon W. Swets

Loans to residential developers, whether it be vacant land, improved land, or the spec homes, the improved properties.

Eric J. Grubelich, CFA – Keefe, Bruyette & Woods

I got you. Okay. That answered my question. Just one last thing. On the deposit side, where are you, sort of, where’s your, like, marginal costs now on certificates of deposit? What’s your posted rate and have rates improved at all on your local market or not?

Philip J. Koning

You know, we’re probably in the 4.2 to 4.5 range for one-year certificates. There are some on the market that are paying quite a bit more than that. We’re trying to lead the market down.

Eric J. Grubelich, CFA – Keefe, Bruyette & Woods

Oh. Okay. Good to hear. Thanks, Phil.

Philip J. Koning

Yup.

Operator

At this time we have no further questions.

Benjamin A. Smith III

All right. At this point I’d like to thank you all for joining us today and we look forward to talking to you again on our next report when we’re very hopeful we’ll have better numbers to report. Thanks again.

Operator

This concludes today’s conference. You may now disconnect.

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