Mercantile Bank Corporation (MBWM) Q2 2008 Earnings Report, Transcript and Summary

Welcome to the Mercantile Bank Corporation’s second quarter earnings conference call. (Operator Instructions) Before we begin today’s call, I’d like to remind everyone that this call may involve certain forward-looking statements such as projections of revenues, earnings, and capital structure, as well as statements on the plans and objectives of the company or with management, statements on economic performance and statements regarding the underlying assumptions of the company’s business. The company’s actual results could differ materially from any forward-looking statements made today due to important factors described in the company’s latest Securities and Exchange Commission filings. The company assumes no obligation to update any forward-looking statements made during this call. If anyone does not already have a copy of the press release issued by Mercantile today, you can access it at the company’s website www.mercbank.com. On the conference today for Mercantile Bank Corporation we have Mike Price, Chairman, President, and Chief Executive Officer, and Chuck Christmas, Senior Vice President and Chief Financial Officer. We’ll begin the call with management’s prepared remarks and then open the call up to questions. At this point I’d like to turn the call over to Mr. Price.

Our second quarter results were severely impacted by the continuation of the credit crisis that’s been in full bloom now for the past few quarters. While our provision for loan loss was significantly lower than our first quarter provision, it was still higher than what we were expecting, but necessary to maintain our conservative posture and a healthy reserve ratio for possible loan losses. As usual, today our CFO, Chuck Christmas, will give you a summary of the financial data for the quarter. Bob Kaminski is on vacation this week, so after Chuck’s comments, I will give you some more color on the asset quality situation.

What I’d like to do is typical, is give you an overview of Mercantile’s financial condition and operating results for the second quarter of 2008 and the first six months of 2008, highlighting the major financial condition and performance balances and ratios. On our earnings performance, we recorded a net loss of $2.6 million or $0.31 per share during the second quarter of 2008 compared to net income of $2.2 million or $0.26 per share during the second quarter of 2007 but an improvement from the net loss of $3.7 million recorded during the first quarter of 2008. We recorded a net loss of $6.4 million or $0.75 per share during the first six months of 2008 compared to net income of $6.5 million or $0.77 per share during the first six months of 2007. The decline in earnings performance during 2008 is primarily the result of a significantly higher provision expense and a substantially lower level of net interest income. The higher provision expense reflects a broad deterioration of the quality of our commercial loan portfolio as state, regional, and national economic struggles have had a negative impact on some of our borrower’s cash flows and the reduction of collateral values. The lower level of net interest income primarily reflects the impact of the steep decline in interest rate that began late in the third quarter of 2007. With our near term asset sensitivity position, we have a higher magnitude of assets subject to repricing when compared to the level of liabilities subject to repricing, combined with an increased level of non-performing assets, along with a very competitive loan and deposit environment, we have experienced a decline in the level of net interest income which has more than offset the growth in our earning assets. Our net interest income during the second quarter of 2008 totaled $10.6 million, a decline of $3.3 million from the $13.9 million earned in the second quarter of 2008 and net interest income during the first six months of 2008 totaled $22 million, a decline of $6.4 million from the $28.8 million earned in the first six months of 2007. Average earning assets equaled $2.03 billion during the second quarter of 2008, an increase of $64 million from the level of average earning assets during the second quarter of 2007. As usual, the growth and earning assets was led by growth in total loans, which accounted for about 90% of the growth in earning assets. Our net interest margin during the second quarter of 2008 equaled 2.15% down from the 2.33% margin during the first quarter of this year, the 2.64% level recorded during the fourth quarter of 2007, and the 2.86% level recorded during the third quarter of 2007. The 71 basis point drop in our net interest margin since the third quarter of 2007 primarily reflects the steep decline in market interest rates that started with the collapse of the sub-prime residential real estate market during late summer and fall of 2007. From mid-September 2007 to late April 2008, the Federal Reserve lowered the fed funds rate and thereby the prime rate by 325 basis points. With about 60% of our loans tied to floating rates, we have experienced a significant decline in our yield on assets. Our asset yield is down about 150 basis points since the Federal Reserve’s first rate reduction led by 180 basis point decline in the yield of our loan portfolio. Current market sentiment is that the Federal Reserve will likely leave rates unchanged in the near term under which forecast we would expect our current asset yield to remain relatively steady. We have also seen a significant reduction in our cost of funds but just not to the degree of the decline in our asset yield. While our asset yield has gone down by 150 basis points since September of 2007, our cost of funds has declined by about 80 basis points. While deposit and borrowing rates have declined, our relatively high reliance on fixed rate Certificates of Deposit and Federal home loan bank advances resulted in a [inaudible] reduction in our cost of funds. With about $465 million in relatively high rate wholesale funds scheduled to mature during the remainder of 2008 and another $520 million maturing during 2009, we do expect our cost of funds to continue to decline throughout the remainder of 2008 and into 2009. These maturing funds carry interest rates that generally range about 75 to 125 basis points above current interest rates. Given the multitude of factors that impact the net interest margins such as Federal Reserve decisions, corresponding changes in interest rates for deposits and borrowed funds, shape of the yield curve, loan and deposit competitive environment, changes in balance sheet structure, level of nonperforming assets, and potential changes in interest rate risk management strategies, it is difficult to predict the future net interest margin. However, under the current interest rate environment, our net interest margin will begin to significantly improve as we move into the second half of 2008 and into 2009. The provision expense during the second quarter of 2008 totaled $6.2 million, an increase of $3.8 million over the $2.4 million expense during the second quarter of 2007, although an improvement of $2.9 million from the $9.1 million expense during the first quarter of 2008. The provision expense during the first six months of 2008 totaled $15.2 million, an increase of $11.8 million from the $3.4 million expense during the first six months of 2007. Our loan loss reserve totaled $31.9 million as of June 30 or 1.74% of total loans. Our loan loss reserve equals 1.67% of total loans at the end of the first quarter of this year and 1.28% of total loans a year ago. Mike will have specific and more detailed commentary on asset quality after my prepared remarks. Our non-interest income totaled $1.7 million during the second quarter of 2008, an increase of $0.3 million or about 24% from the $1.4 million earned in the second quarter of 2007. Non-interest income totaled $3.6 million during the first six months of 2008, an increase of $0.8 million or about 29% from the $2.8 million earned during the first six months of 2007. We recorded increases in virtually all fee income categories during the first six months of 2008 compared to the first six months of 2007. Service charge income was up about $202,000, mortgage banking income was up about $199,000, and bank on life insurance policy income was up $247,000. Non-interest expense totaled $10.8 million during the second quarter of 2008, an increase of $0.7 million over the $10 million expense during the second quarter of 2007. Adjusting for the one-time $1.2 million expense associated with former Chairman Johnson’s retirement package that was recorded during the second quarter of 2007, the increase in 2008 over 2007 was $1.9 million. Non-interest expense totaled $21.1 million during the first six months of 2008, an increase of $2.3 million over the amount of expense in the first six months of 2007, again adjusting for the one-time expense during 2007, the increase in 2008 totaled $3.5 million. The majority of the non-interest expense growth during the first six months of 2008 when compared to the same time period in 2007 relates to costs associated with the administration and resolution of problem assets including legal costs, property tax statement, appraisals, and write downs on foreclosed properties. These costs totaled $1.1 million during the second quarter of 2008 and $1.5 million during the first six months of 2008. During the first six months of 2007, these costs totaled only $0.2 million. Write downs of foreclosed properties comprised the majority of the costs, equating to $0.7 million of the $1.1 million expense during the second quarter of this year and $0.9 million of the $1.5 million expense during the first six months of 2008. One other expense item of note is increased FDIC insurance premium assessment, an increase of $0.5 million during the first six months of 2008 when compared to the first six months of 2007. Our funding strategy has not changed significantly as we continue to grow local deposits and bridge the funding gap with wholesale funds, namely brokers, CDs, and Federal loan bank advances. Our average wholesale funds to total funds during the second quarter of 2008 was 63% compared to 61% during the first quarter of this year, with the reduction or the increase primarily reflecting funding our asset growth and also less public unit CDs. Given the lower interest rate environment on Federal home loan bank advances when compared to the brokers CD market, we have replaced some maturing broker CDs with Federal home loan bank advances. Federal home loan bank advances have increased $150 million over the past 12 months, including $105 million during the first six months of 2008. We remain in a well-capitalized position for bank regulatory definitions with a consolidated total risk base capital ratio of 11% and a bank total risk base capital ratio of 10.8% as of June 20th of this year. The bank’s total regulatory capital equaled about $225 million at the end of the second quarter of this year, approximately $17 million in excess of the amount needed to provide for the 10% minimum well capitalized total risk based capital ratio. That is my prepared remarks. I’ll be happy to answer any questions in the Q&A session but now I turn it back over to Mike.

Regarding asset quality, which, along with margin improvement, continues to be our main focus, the second quarter saw a non-performing assets increase by $6 million to $46.6 million or 2.16 of total assets. During the quarter we placed $15.5 million in new loans in non-performing status. We collected $4.6 million in pay downs and took $4.9 million in chargeoffs or ORU write downs. As far as a breakdown of what’s in the non-performing assets by loan type, $12.4 million is residential land development loans, $3.5 million is in commercial land development, $2.3 million is in one to four family construction, $3.2 million in one to four family housing, $7 million in commercial owner-occupied, $10.2 million in commercial non-owner occupied, and $8 million in the C&I category. During the quarter the largest net increase occurred in the category of commercial land development of $3.5 million and the largest decrease occurred in the category of commercial owner occupied of about $2 million. The majority of the $15.5 million addition to the non-performing assets came from 8 relationships, all of which had been previously identified as watch list loans. As of quarter end, about 40% of our non-performing loans remain contractually current. None of these current customers remain current through funded interest reserves, but despite the current status of these current loans, management feels that conditions point to potentially serious issues with cash flows in the near future. The fourth quarter of 2007 was a period we recognized the potential for loss in a residential real estate development area. The first quarter of this year saw an increase in commercial real estate and some C&I downgrades. This quarter the theme really was largely centered on downgrades and chargedowns on previously identified relationships where new appraisals and/or the liquidity of guarantors have demonstrated significantly lower values or capacity. While the continual erosion in real estate values have been a source of frustration, and estimating embedded losses within the loan portfolio, we have seen some recent indications that we may be nearing the peak in our non-performing asset level. Positive trends in our watch list totals and positive trends in the past due 30 to 89 loan categories have shown improvement during the quarter. We are seeing fewer new credits add to the watch list and the totals for the past two months have trended downward. As additional color, it is interesting to note that our accruing 30 to 89 day past dues totaled only $1.4 million at June 30. This is the lowest that total has been since early 2006 and compares very favorably with the March 31 and December 31 totals of $3 million and $7 million respectively. Past history has shown that the vast majority of non-performing assets and losses migrate from the past due and watch list totals. While there certainly remains challenging headwinds within the marketplace and our performance was not what we had planned for, for the first time in four to five quarters we are more encouraged than discouraged as the direction of our asset quality and numbers in the short term. In the meantime we will continue to manage our balance sheet from a well capitalized position, keep overhead costs well managed, continue to work on building a stronger margin, and keep a strong focus on reducing those non-performing assets. At this point we’d like to open the lines up for questions.

(Operator Instructions) Your first question comes from Steven Gayain - Stifel Nicolaus. Steven Gayain – Stifel, Nicolaus and Company, Inc. : Could you discuss one more time the watch list, the trend in watch list credits and the model, what was the amount of the 90 days past due?

The watch list totals during the quarter started out very stable and towards the end of the quarter we actually saw some fairly nice reductions in the total amount of loans on the watch list. It’s the first time that’s happened in probably over a year, maybe well over a year, and that has continued on into the quarter here as we are starting to see some resolution, starting to see some credits actually being upgraded. We’ve been very, very aggressive in putting anything that we saw weakness on, non-performing in the watch list, and some of these situations fortunately have turned around or been resolved, we’ve been able to move them out of the bank. As far as the 30 day to 90 day past dues, I don’t have them broken down by category but the majority of those are in the 30 day total and the total of all three categories was $1.5 million which as I said before is significantly below the $3 million that it was at the end of last quarter and in December it was $7 million and it was at that $7 million total for most of the last few months of ’07 and we haven’t seen numbers that low since early ’06. So we’re feeling pretty good that we finally have seen some numbers that would indicate that the new stuff that is coming into either the watch list and/or past dues has started to drop at a fairly significant level. As I said in my comments, the quarter really felt like we had finally gotten our hands around and quarantined problem loans and almost all of the losses, although they were more than what we expected, came from that list. We just continued to beat that list down and down and down and it’s been frustrating because we’ve gotten in some cases two or three new appraisals and obviously what’s going on out there, we felt it prudent to write it down to what the new appraised values are, or there’s been a couple of situations where we had this year or this quarter, some guarantors who have been pretty well heeled and have been making some payments, just run out of that liquidity, so if there’s any good thing we can take out of what happened in the quarter on the asset quality side, it’s the fact that very few new names are being added to the list and we continue to write down the problems ones at a real aggressive pace. Steven Gayain – Stifel, Nicolaus and Company, Inc. : And do you have any idea of what the value of the loans are that are currently working through the interest reserves of those loans that are not performing?

Well that’s what my comment earlier was meant to address that, so I appreciate you asking the question so I can make it clear that we had none of the loans that are past due or [inaudible] interest reserve. I know that was a big article and rightly so that the FDIC was very concerned about that. It appeared in the New York Times but we’re not holding any credits or those no credits in the portfolio that we’re concerned about that are staying alive by funded interest reserves.

Your next question comes from Eileen Rooney - KBW. Eileen Rooney - Keefe, Bruyette & Woods : Mike, about the second quarter was all about downgrading previously identified credits. How much would you say you’ve written down most of the non-performers, say in the residential development portfolio?

It’s what we’ve done, we’ve been pretty aggressive like during the quarter, the $6.2 million in provision we set aside $1.8 million of that was in further downgrades of stuff that we’ve already had identified as problems, either on the watch list or in MPA from quarters past, so there was some significant downgrades in those areas. As a percentage, it really varies, depending upon loan by loan. We got rid of some MPAs during the quarter that we didn’t discount at all. We were able to sell them because of where they were and the values but we’ve had two or three deals where we were 80% loan of a deal according to the original appraisal and we’ve written them down by 15%, sometimes even more.

Your next question comes from Jon Arfstrom - RBC Capital Markets. Jon G. Arfstrom – RBC Capital Markets : . Chuck, a question for you on something in your prepared comments. You said $1.1 million of the expense line was from the cost associated with problem assets and if my math was right, it’s pretty easy, but $400,000 in the first quarter?

Correct. Jon G. Arfstrom – RBC Capital Markets : . How much of that $1.1 million would you say is perhaps one-time in nature and how much of that lingers on into Q3 and Q4?

Of the $1.1 million, Jon, for the quarter, about $700,000 of that was associated with write downs of foreclosed properties and what dovetails with what Mike was just talking about with some of our non-performing loans and we certainly continue to re-evaluate those properties at least on a quarterly basis, quite frankly, even more readily than that, and hopefully we’re getting towards the bottom of some of these evaluation [degragations]. We certainly believe that as of June 30th that we’ve got other real-estate owned properties marked down to what our net sales price is going to be and obviously only time will tell as to how accurate we are but we’ve tried to take an aggressive or conservative approach when making those write downs. Jon G. Arfstrom – RBC Capital Markets : . Can you touch a bit on the asset quality trends in commercial mortgages for the non-construction and development and also the straight C&I loan book?

As far as the non-residential commercial CRE, we are not seeing a lot of new issues coming up in there. That’s been holding in there pretty well. Unfortunately we put about $1.7 million in provision this quarter and it was largely three deals that we had already had as non-performers. They’ve come back with new appraisals and we just downgraded them and put some estimated further losses on them so the bad news is that obviously some of those values are even further eroded but those three particular credits have been written down now to some pretty darn low values. The C&I, again, there were about four or five large deals in the C&I downgrades. They were all deals that were either already on the watch list or already in MPAs and a couple of them are current but again we see reasons to see weakness in them and we thought it prudent to further right them down and it goes back to my earlier comment that so many of them that we saw this quarter, almost everything we saw this quarter, came from existing deals that we have identified and the number of new credits added to the watch list in the quarter was extremely saw and that combined with the number of the new past due loans gives us a lot of optimism going forward. Jon G. Arfstrom – RBC Capital Markets : . In terms of the loan pipeline, I know that this is not the environment for the Mercantile of old in terms of quarterly loan growth, but you made some comments in the press release about some competitive pressures waning and theoretically with some of the watch list credits coming down, I guess the question is there an opportunity to continue to grow the company perhaps at a bit faster pace than you’ve seen over the last few quarters?

There certainly is that opportunity to build loan totals. Whether or not we take that opportunity is going to be a question of capital used in the appropriate way. The good thing about it, Jon, is that for the first time in a long, long time, we’ve been talking on these calls about rationality coming back to deal structure, well all of a sudden we’ve seen, which is a welcome thing, rationality coming back and loan pricing. Some of our biggest competitors are basically out of the commercial real estate business and we certainly aren’t there to become the largest strip mall and CRE lender in the United States, that’s for sure, but clearly the opportunity now for those selected relationships that we would like to take is there and the better part of that is that the opportunity to price them correctly is there because there’s just a lot of people out of the market now and that’s a real positive going forward. The loan growth that we did have in the last quarter, a lot of that was significantly good C&I stuff that we put on the books and have very very strong performing credits and very glad to get those on. Jon G. Arfstrom – RBC Capital Markets : . One other question about the geographies of your company, do you feel like there’s any difference in terms of the economic strength in Grand Rapids compare to Lansing and Ann Arbor?

There’s clearly differences in the markets. The nice thing about being relatively new in Lansing and for example Washtenaw and Novi is that even though the east side of the state is depicted as being horrible and that type of thing, Oakland County for example and Ann Arbor have some pretty good economies going over there relatively speaking. We haven’t seen anything that would indicate that there’s significant issues with any of those economies and marketplaces that we’re involved in over there. A lot of people scratch their head and say, “Gee, why is Mercantile going into Lansing?” but that particular location for us has done extremely well with deposits and loans and they have a very, very low MPA number there so a lot of it is again the ability to attract good people and the ability to stay away from the bad particular loan types that have been plaguing us.

Your next question comes from Michael Cohen - Sunova Capital.

Can you talk about any credit tightening you are doing on the loan growth? I mean in addition to getting to the wider pricing, are you requesting higher loan to value or tighter underwriting as the case may be?

I think you’re probably asking are we asking for a lower loan to value but I understand what you mean. We are and certainly we have taken an opportunity over the last couple of years to do a lot of self-examination to see what we could do to make not only our underwriting criteria stronger but the way we prosecute putting loans together and getting out there through the approval process and we reduced some individual lending authorities so that forces more stuff to bubble up if you will in through the loan committee process and to senior management and to the board, so I think those things have helped greatly. We’ve looked at tightening up the way that we monitor any type of borrowing formulas or any type of past due property taxes whereas in the past we might let some of those go because everybody has a story, if you will. We really are starting to move more and more and more towards any modifications we have and done just to zero tolerance. This is the way it’s going to be and that has helped us greatly in the short term.

You were talking about some of the C&I credits and so forth and I noted in the last sentence of the third paragraph on asset quality, you said commercial non-performing assets were roughly $29 million at June 20 compared to $23 million at March 30, 2008. Is that all commercial or is that intended for like commercial and industrial? What’s driving that $5 million delta because it doesn’t seem like that would include the land loan stuff.

That’s just the commercial portion of the IPAs.

So that would seem to be a fairly sizable increase, no, or?

There have been some sizable increases through there and again, as we’ve talked about, there’s ones that we’ve had on the watch list, ones we’re watching, and we haven’t seen anything new pop up on the watch list, if you will, to replace them, fortunately.

Great, that’s good news and then can you talk about what you’re seeing in terms of the local economy and the impact of higher fuel prices in talking to some of your commercial customers and how they’re thinking about it impacts some of their businesses. Have they passed on price increases to customers, are they expecting price increases from their suppliers? Can you talk about what you think that’s going to mean or how it has or hasn’t yet translated into the numbers?

It ‘s a great question and it’s really the question of the day out there within our commercial customers and quite honestly there are some customers... I think just about everybody’s impacted by higher commodity prices one way or another and as bankers you learn about how many things are part of somebody’s cost of business is made out of oil or oil derivatives, but the interesting thing is, and I guess the challenging thing is, is that there are certain industries that are much more flexible in allowing our customers to gain price increases and those industries obviously, as you might imagine, we’ve got customers that are doing very, very well in recapturing those costs. There are other industries, transportation being one, and some other industries, that it’s a trickier deal. It’s a little harder. It’s not as traditional to see the fuel surcharges for example recaptured, and even when they are recaptured, it has impacts on our customers because they may get the fuel surcharges three months down the road reimbursed to them, but meanwhile that means they need a larger line of credit, larger interest expense, and that type of thing. It is a very fluctuating, fluid, and dynamic environment out there and one that really requires us to A) sit down with our customers on a very constant basis and say, “Look, how is this affecting you? What are you doing about it?” and for us to make the tough calls and if they’re not doing enough or if the market just isn’t allowing them to recapture those things is to try to move them down or out of the bank and that’s a tough deal. Then we sit down with the ones who say they can and you ride with them a little bit and watch how it impacts them. As far as new credits go, that’s one of the first questions we have for everybody that walks in the door. Show us what the impact is, tell us how you’re dealing with it, and that is one of the highest on your list of credit metrics that’s probably risen to be one of the highest and first five questions we ask somebody today is “What’s going on in that part of your business?”

In terms of loss severity on construction credits, what are you averaging across the board if you will in terms of your total write off. Not necessarily what you had, what you’re taking today, in other words, what you might have taken in the past plus what you may take at this given period, what’s the charge off to the original principal balance.

We haven’t, and I think I know what you’re asking, and it’s a good question, but we haven’t sat down and said, “Okay, here’s the losses we’ve taken and let’s divide it by the original gross loan and come up with an average” and the reason why is we don’t think there’s a real correlation there because, as I mentioned earlier, there are some projects that we’re getting back that we’re getting out of without taking a loss. We give people, and you might imagine, those for example commercial real estate, those with high occupancy levels where something’s gone wrong with the borrower maybe with another project or another issue or whatever, those that have higher levels of occupancy are fairly easy to still get rid of on the marketplace but as those levels go down the scale, you start taking bigger and bigger hits as you might imagine, so there are sometimes we have gotten out whole, there are a whole lot of times we take 5% to 10% hair cuts, but there are times and we’ve talked about this quarter where we’ve got 2 or 3 severely impacted projects that we’ve written them down by 50%.

Understood, but if you were to narrow that focus simply to construction and development/land, could you provide some perspective on just that narrow category?

You have the same dynamics with that narrow category and you’ll certainly, I think today what you’re seeing on land development and construction that’s in a non-performing situation is anywhere from 10% to 15% on the low end of some of those projects.

I can imagine regulatory discussions just across the industry are becoming much more detailed and lengthy. Can you characterize your regulatory discussions or at least when you completed your regulatory exam?

I’ll give you back to Chuck in a minute to give you some of the granularity on that since he has some of the significant conversations and can probably remember the date they left here better than I can, but I will tell you that clearly making sure we remain in an extremely well-capitalized position is one of the main reasons why we cut the dividend, obviously, and we are very very focused on managing the bank so that we remain in that position because of, you’re exactly right, that’s the big subject of the day out there for all financials, and Chuck I think can probably give you some more clarity on your other part of the question.

As all banks are examined annually, we traditionally have our examination late in the fourth quarter of each calendar year so they left the bank and met with the board in the early part of the first quarter and no disagreements or anything like that. Certainly things are obviously being examined on an ongoing basis. We obviously talk to other bankers, talk to trade groups. I do occasionally talk to the local folks at the FDIC who is our primary Federal regulator on an occasional basis when the bigger issues and as an example they called on Monday asking how the broker CD market was handling the [Fannie Mac] situation over the weekend which I can happily report that it really has been no impact whatsoever in the broker CD market as a result of that. The [Fannie Mac] situation which is very, very unfortunate was handled and is being carried out just as everybody would have expected it to be carried out, so we obviously have the big discussions when they’re onsite for the three or four weeks that they are each year. Obviously it’s been six, seven months now since they’ve been here, but we do have an occasional conversation with them directly just on some of the bigger items such as the broker CD market.

Your next question comes from Steve Covington - Steven Capital.

Do you disclose what your level of specific reserves are in the allowance versus any type of allocator formula driven reserves?

We traditionally haven’t provided that. I don’t know if it’s a big secret. I don’t know if we’ve ever been asked that question before. I don’t have that information.

I’m just trying to get a feeling for where you might run or where your formula will drive your reserve.

Let me touch on that a little bit and obviously we’re in a very dynamic and fluid situation there. I can say a vast majority of our loan loss reserve are general allocations and not specific reserves. If I had to just guess I would say specific reserves are probably in the neighborhood of say $6 million but that’s a neighborhood guess as I sit here. So you would likely see some continued higher than traditional certainly in chargeoffs from the company over the next few quarters although we would expect that though we do process that a pretty high percentage of those chargeoffs will be the elimination of specific reserves as we move through the process of identifying the credits, setting up the reserves, and obviously coming to some resolution with those credits, whether it be the chargeoffs, foreclosures, or maybe fronting the situation by improving the overall borrowing relationship with that customer such as additional collateral or those types of things.

Your next question comes from John [Baybo] - Flint Rich Capital. John [Baybo] – Flint Rich Capital : You noted that the structure of the loan environment has improved. What do you think it’s going to take to get the deposit environment to improve? You mentioned a little bit about that in answer to the prior question but what’s the potential for that to improve your margins say over the next year to 18 months.

We certainly would look at that from a positive standpoint. A lot of our deposit growth, especially the demand in deposit growth, is going to come from commercial loan relationships. As a commercial bank obviously we try to tie that into the loan, so when we do bring on a loan that, as Mike touched on already, during the second quarter a lot of our loan growth was the C&I and quite frankly that’s where a lot of the demand in deposit growth is going to come from, so just a pick up in loan growth is certainly going to help the local deposit numbers. As we’ve seen, some of the bigger players step back from the market place. That would seem to be, it is more of a recent phenomenon so we really haven’t seen it totally in the marketplace yet, but it would seem to me that if they were to step back from their lending that their demand for funds for deposits would lessen and hopefully that would put less pressure on the deposit competitive environment and therefore we see a little bit lower rates. One of the issues we’re definitely grappling with with some of the players in our marketplace with the headlines that they’ve been getting, I think they’ve had some rather significant sign that runs for the banks where customers get nervous and customers start withdrawing some of their funds, especially may be the uninsured portions, and I think to counter that we’ve seen some pretty aggressive CD rates, some CD campaigns in our marketplace, rates that are significantly above the broker rates that certainly we’re not going to match. We traditionally have always tried to be in the top three of our banks when it comes to deposit pricing but quite frankly some of these specials that we’re seeing out there are well above what we think is appropriate and in fact are well above broker CDs so I think to summarize, I’m hoping that with the loan growth we’ll see some deposits there and maybe with some of these other banks stepping back a little bit, they won’t be so aggressive in trying to raise local deposits and hopefully that transpires into some lower locals deposit rates. But I think on an overall basis, the marketplaces that we’ve been in have traditionally been quite a bit higher than most of the other markets throughout the country. We see that through the broker CD pricing, so I think that we’re always going to stay a little bit above but hopefully from what we’ve seen over the last 6, 12, even 18 months, hopefully we’ll see less pressure there. John [Baybo] – Flint Rich Capital : You mentioned I think the $500 million roughly that of higher cost funding that’s rolling off this year and then $500 million next year. Is that spread fairly [radibly] across the calendar or are there any bigger deposits at a particular time period?

We try to keep a relatively laddered approach. Most of our funds, because of the relative short term nature of our asset size, are going to mature within 12 months. I would say if I had to guess right now, I haven’t calculated it yet, our average maturity is probably somewhere between 8 and 9 months. It just so happens that July this month is actually one of our biggest months ever. We have about $100 million set to mature this month at a cost of about 5.02% but on an average basis going forward over the next 12 months, it probably averages somewhere in the $60 million to $80 million range. Once you get past 12 months it’s more of the $15 million, $20 million range for the next 12 months after that. John [Baybo] – Flint Rich Capital : Okay, and then would it be fair to say then that from an interest rate environment or from an interest rate standpoint, you would be okay with the status quo or would you actually prefer to see rates increase?

Selfishly, if it were just to look at a short term, certainly an increase in the prime rate would be very beneficial to us, because not only would we see a continued reduction of the cost of funds, but obviously we’d also see an increase in the asset yield of our loan portfolio but that short term thinking, certainly with the economic struggles not only just local and regional but certainly national, obviously an increase in the prime rate would put additional pressures on our borrowers so that might tip the asset quality scale a little bit. It seems to me that we’re probably going to sit here with some relatively stable rates with regard to prime and some of the other things for the next couple quarters but it’s been a very, very volatile market. It seems like minds are changed significantly from day to day or week to week anyways and so we try to manage the best that we can do that. Our thought process is that the prime probably doesn’t change for the rest of most of this year anyways, at least wouldn’t have much of an impact on this year and with that we expect a stable asset yield but with the continued reduction of our cost of funds. John [Baybo] – Flint Rich Capital : Okay, and then you mentioned with regard to asset growth that capital usage would be an issue. How do you feel about your capital situation and if you wanted to grow that loan portfolio a little bit more aggressively, are there any steps that you could take to accelerate that process?

We certainly feel good about our capital situation obviously. We’ve always felt very, very important for us to remain in good excess of being well-capitalized but we want to make sure that we stay that course through these rough waters here. From a competitive standpoint and from a marketplace standpoint, there’s a lot of volume that we could probably start to bring on but we want to make sure that we bring it on judiciously. We have no plans in going back to the Mercantile of old if you will right now anyway of saying, “Gee, we’re going to grow about $1 million in a year” type of thing. But there is some opportunity there now where if we want to and we’re looking at these situations very, very closely, we’re really learning more towards C&I obviously than CRE but to look at some situations and get the proper pricing and a proper deposit mix and bring some on board. John [Baybo] – Flint Rich Capital : So is it fair to say that the incremental net interest margin on the new loan growth is higher than the current net interest margin?

Yes, we’re very careful to make sure that we look at whatever we bring on to make sure that it’s a very profitable situation, whether it be through a combination of net interest income, fee income, ancillary business, or all the above. John [Baybo] – Flint Rich Capital : In looking at your March Q, the construction and land development. Do we know what percentage of that is residential versus true commercial?

Well the land development portfolio is about $135 million with about another $54 million in one to four family residential housing construction, so it’s about $189 million as of the end of the quarter. John [Baybo] – Flint Rich Capital : And so when you say land development, that would be commercial?

That’s residential. John [Baybo] – Flint Rich Capital : Are there any other relationships there that maybe aren’t on the watch list but are things that you’re watching carefully?

We tried to throw starting in the fourth quarter of last year any residential land development deal that wasn’t just doing great with a whole lot of belt and suspender to it, we tried to throw that on the watch list and I think just to give you a little bit of color on that, there’s $135 million in residential land development. That’s the total portfolio. About $12 million of that is in non-performing right now. So you’re almost approaching 10% of that particular slice of the portfolio is already on the non-performing list and some of that, as I’ve mentioned before, is even paying every month, contractually current, but it’s residential real estate development and we just don’t like it so we’ve shoved it in the non-performing area and if we can collect it all and get our interest later, we’ll be happy, but right now we’re being very conservative in putting it there. John [Baybo] – Flint Rich Capital : So if you had to look at it from a credit quality standpoint, are you more concerned about that residential loan portfolio versus say the commercial business or do you think we’ve seen the worst in the residential and now you’re just --

I think you’d like to say you’ve seen the worst in the residential and from the standpoint that during the last two quarters since we really went through and scrubbed the portfolio in December, the last two quarters have seen very, very little, if any, new residential land development come out of the watch list. The biggest issue we have is just as we’ve gone through and as every bank is doing right now, you go out and you say, “Okay, obviously we had an appraisal when the loan was made, whether that was two or three years ago or whatever. Now let’s get it re-appraised.” You get these new values in and they indicate, “Holy cow.” They taken another 10% or 15%, sometimes 20% hit, and that’s what we’ve really seen as far as the last two quarters in any downgrades in that particular area. We had one, the only codicil, we had one relatively large relationship where a person with a very large net worth lost that net worth in a very short period of time and was no longer able to keep the payments up to speed. John [Baybo] – Flint Rich Capital : Should I assume that most of those loans were written at 75% loan to value?

Yes. They were all conforming loans at the time they were made but obviously with what’s happened out there in the marketplace, they don’t look so conforming anymore. John [Baybo] – Flint Rich Capital : Right, and so in terms of the ultimate recovery of those assets, whether it’s returning to performance status or liquidating the assets that you need to foreclose, do you really need to see a pick up in residential construction or do you think that the prices have gotten to a point where maybe some longer term investor type money is going to come in?

We have seen the last couple of quarters now people who are starting to say, “Gee, these residential lots that two years ago were selling for $45,000 to $50,000”, people are actually coming in and actually buying them at $20,000 kind of thing, so they’re seeing that 50% reduction, and that does seem to be a spot that certain people are coming in and buying them and it’s not a ground swallow. We don’t have tons of people coming form around the country say, “Let’s buy Michigan real estate” but there are all people now, we are starting to see some movement, we are starting to get pay downs on some of these deals, they certainly don’t come in as quickly as we’d like, where everybody I think when these loans are made, we’re assuming 5 to 10 lots a month would be sold. Now we may get a couple a quarter or maybe one a month, if we’re lucky, two a month, but that is progress and we are starting to see that happen. John [Baybo] – Flint Rich Capital : In terms of the residential real estate values, have you seen that stabilize in your geographies?

We have. They stabilized at very, very low numbers but they have stabilized and I think that’s a good sign going forward. We actually are seeing in certain markets, and Grand Rapids is one of them, we’re actually seeing the number of sales per month going up compared to a year ago. What’s shocking to the market to people who are selling and the banks and everything is that the number, the average sale price, is significantly down, and I think that’s the new paradigm we’re going to be operating for a while. I think sellers are finally realizing that if I had a $400,000 house or at least I thought it was, it might be appraised and SEB might be there, in fact today it may be a $310,000 house or some such number. But we aren’t seeing that total free fall of prices that we were earlier, it’s just that what stabilizes is a pretty low number, it’s a shocking number, when you think of the history of real estate in the United States. John [Baybo] – Flint Rich Capital : Right, and those folks that are buying at that shockingly low number, they’re not having any problems getting financing?

That’s a good question. If you’re buying, when I say buying, I’m assuming that those people are getting financing. But there’s no question that getting financing is harder than it should be today. We’ve fortunately watched a lot of these brokers out of the market that caused the sub-prime thing, that’s causing all the rest of us to suffer through the implications of that, but clearly you actually need to show that you have income now and you need to show that you can manage your credit and it’s almost like it was 20 years ago, and that’s okay by us. John [Baybo] – Flint Rich Capital : Just as an aside, do you think that community banks in general are better positioned to try to get through this and that you might see a return to that older style banking where your community bank is going to hold your mortgage and they’re going to fund your business.

Depending on what happens with Freddie and Fannie, we may be having that. Hopefully Freddie and Fannie will be just fine. They appear to be. I think a lot of us community banks really, we have been old style lenders as far as we like to see income and we like to see verification of collateral and that type of thing, but the world got real ahead of itself on this real estate market and even though again we were the old fashioned 80% for example on residential real estate development loan and we took guarantees and everything. When those values drop from 100% of what they were selling to 50%, and the velocity of sales goes to trickle, it can just stress community banks, regional banks, and very large banks all alike, as well as certainly the developers who most of them end up going out of business and losing their net worth.

We have no further questions at this time.

Thank you very much. Thank you all again for your interest n the company. We again are disappointed with the loss but for the first time as I said earlier, in many quarters we feel that the margin is poised to show some significant improvement here over the next few quarters and certainly the pace of asset quality issues, at least as I look at the end of the quarter and the first few weeks of this quarter, look like they significantly subsided. We look forward to talking to you at the next quarter.