Mercantile Bank Corporation (MBWM) Q1 2020 Earnings Report, Transcript and Summary

Good morning, and welcome to the Mercantile Bank Corporation First Quarter 2020 Earnings Results Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Mike Houston, Investor Relations. Please go ahead.

Thank you, Grant. Good morning, everyone, and thank you for joining Mercantile Bank Corporation's conference call and webcast to discuss the company's financial results for the fourth -- for the first quarter 2020. I'm Mike Houston, with Lambert IR, Mercantile's Investor Relations firm. And joining me today are members of their management team including Bob Kaminski, President and Chief Executive Officer; Chuck Christmas, Executive Vice President and Chief Financial Officer; and Ray Reitsma, President of Mercantile Bank, Michigan. We will begin the call with management's prepared remarks and presentation to review the quarter's results then open the call up to questions. However, before we begin today's call, it is my responsibility to inform you that this call may involve certain forward-looking statements such as projections of revenue, earnings and capital structure as well as statements on the plans and objectives of the company's business. The company's actual results could differ materially from any forward-looking statements made today due to the 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 the call. If anyone does not already have a copy of the first quarter 2020 press release and presentation deck issued by Mercantile today, you can access it at the company's website www.mercbank.com. At this time, I'd like to turn the call over to Mercantile's President and Chief Executive Officer, Bob Kaminski. Bob?

Thanks, Mike and good morning, everyone. At the conclusion of our call in January when we told you that we look forward to speaking with you in April, none of us could have imagined how our world was going to change in just a few short months. On the call this morning we will provide details of our performance for the first quarter as usual, but we will also spend a significant amount of time in our comments discussing the items, which we believe will be of interest to you in the wake of the COVID-19 pandemic. COVID-19 has obviously created a life-threatening crisis around the globe. As February ended, it became more and more apparent that the virus was rapidly spreading in the United States and action had to be taken. First and foremost, Mercantile worked expeditiously to ensure the health and safety of our employees and customers and our detailed response is noted on slide 3 of the presentation. As concerns over the pandemic in the U.S. and Michigan started to grow, Mercantile worked to limit face-to-face contact with our customers beginning on March 18 eventually leading us to the full closure of our lobbies beginning -- of our lobbies with Governor Whitmer's stay-at-home order on March 25. Customers are able to continue fulfilling their banking needs with our drive-thru facilities, video banking machines and electronic banking. Since the beginning of the crisis for example, our daily retail online banking logins have almost doubled. Regarding our staff as mentioned on slide 3, since March 23 at any day we generally have over 75% of all employees working remotely from home. And some of the gracious feedback from our customers can be seen on slide 4. As we have discussed in recent years, Mercantile has worked continuously since the end of the Great Recession to place ourselves in a position of strength. The goal is to leverage the opportunities of a solid economy, but to also provide our company with strong financial metrics that allow us to be successful during weaker economic times. While the pandemic certainly creates new challenges for everyone in the financial services industry, our foundation remains extremely solid as we work with our clients to help them weather the storm caused by this crisis. During this call, we will be providing you with details on our loan portfolio including metrics on some areas of focus as we work through the issues presented to our industry. We'll talk about our historical credit quality leading up to the crisis, loan concentrations including breakdown by loan type as well as non-owner-occupied real estate versus owner-occupied real estate and our C&I portfolio by industry classification. We will also discuss activity with our clients relative to our payment relief program for existing loans during the pandemic. We'll also talk about our efforts to provide funds to our clients through the SBA with the payment -- Paycheck Protection Plan. We'll discuss our key metrics including liquidity and capital position as well as the position Mercantile is taking regarding the new rules that allow the postponement of the adoption of CECL. We will discuss the impact on our non-interest -- our net interest margin by the actions taken by the FOMC at the start of the crisis to boost the economy. With cuts in interest rates, our mortgage banking business has been able to generate record pipeline volumes comprised primarily of refinances. The stay-at-home mandate is making the new purchase activity quite challenging at the current time, but real estate agents and consumers are trying to be creative with real estate movement while maintaining compliance with the executive orders. Michigan has unfortunately been a hotspot for COVID cases. Southeast Michigan including the City of Detroit is a large metropolitan area that has been hit very hard with confirmed cases and death skyrocketing in early April. The areas of the state where Mercantile remains maintains the vast majority of its market presence including Kent County and West Michigan along with the central part of the state have seen its critical statistics increasing, but at levels allowing the health care systems to keep pace with the spread. Social distancing in conjunction with the state mandate has caused citizens to remain at home with the exception of those working in essential critical industries. Many local businesses have engaged federal stimulus relief to help keep their employees paid as their state waits for the virus cases to subside so the economy can be safely reopened. Before this crisis, the Michigan economy was generally steady throughout 2019. Some areas of manufacturing had a down year but unemployment was low real, estate prices continue to increase and the tourism industry continued to exhibit strength. It is certainly everyone's hope that as infections from the virus subside and plans for lifting the restrictions on movement in our communities are implemented that the economy is driving force, which is the consumer returns with ample energy to jump start businesses that have been placed in hibernation. We'll continue to monitor the situations closely and be prepared to take additional measures if those needs arise. As always, we remain confident in our positioning that continues to strongly serve our customers as we navigate through and eventually out of this ever-changing environment. Those are my introductory comments. I'll now turn it over to Ray.

Thanks, Bob. Our loan portfolio increased $45 million in the first quarter of 2020 with each of our markets contributing to that growth. Our pipeline remains solid as well with $77 million of commitments in commercial construction and development loans, which we expect to fund over the next 12 to 18 months should a semblance of normal construction activity resumed during that time frame. Our asset quality remains strong as non-performing assets totaled $3.7 million or one-tenth of 1% of total assets at March 31. We recorded non-interest income during the fourth quarter of $6.5 million, up $1.8 million or 38% from the prior year first quarter excluding $1.9 million in non-recurring items related to that quarter. This improved level of non-interest income was largely driven by increased mortgage banking income, reflecting the success of ongoing strategic initiatives designed to increase market share and a higher level of refinance activities stemming from a recent decrease in rates continuing to enhance mortgage banking income through increased market share including an increased share in the purchase market remains a priority and we will continue to hire proven mortgage loan originators when we are able. We also recorded continued growth in the quarter in other fee income categories including credit and debit card income, service charges on accounts and payroll processing fees. Credit and debit card income has trended downward as stay-at-home orders were implemented in March and are scheduled to remain in effect through April 30. The exercise of discipline related to overhead costs as we focus on efficient delivery systems in all of our lines of business remains a priority. The onslaught of the COVID-19 virus provided an opportunity to demonstrate the value of community banking combining high-touch service with strong capabilities. As Bob mentioned our electronic banking capability allowed us to close our lobbies on March 25 and contributed to an ability to have three-quarters of our employees work from home from that date forward. While many banks labored under the SBA Paycheck Protection Program, Mercantile funded over 1,500 applications representing over $500 million in loans, supporting thousands of workers in our communities and contributing to the maintenance of asset quality as the crisis plays out. Our communities have been consistent in providing us with supportive feedback, praising our commitment to professionalism throughout the process. Some of this gracious feedback from our customers can be found on slide 4 of the presentation as Bob mentioned. In addition to the federally funded SBA programs as you can see on slide 5, Mercantile created payment deferral programs allowing interest-only programs and total payment deferral programs for entities directly impacted by the COVID-19 crisis. Next, on slide 6, while consumer lending is a small proportion of our portfolio at approximately $30 million over 500 hardship inquiries have been logged by our customer service team and less than 50 cases -- and in less than 50 cases have our customers requested implementation. Our past due list on slide 7 has maintained the proportions of the pre-crisis world as of March 31 and to date in April as well. The risk rating process as seen in the next slides reflects a portfolio of strong characteristics, reflecting the strength of the pre-crisis economy. Maintaining accurate risk ratings will remain a key focus in the upcoming quarters. We will be paying particular attention to the financial condition and performance of credits in the following segments: automotive dealerships, hotels and lodging, assisted living, restaurants, construction, movie theatres, and retail. None of these individual segments account for more than 5% of the commercial loans. Turning to slide 11, we will go over some of the details of the recent programs implemented by the CARES Act and the Federal Reserve. Paycheck Protection program provides for forgivable loans to eligible small businesses to maintain employment during this pandemic. The loans carry a 1% interest rate and deferred payments for the first six months and monthly payments for the following 18 months. The loans may be forgiven if the funds are used by the borrower for payroll rent and utilities in the specified proportions. The SBA also provides an origination fee of between 1% and 5%, which is paid within five days of closing. The deferred income is accretive to interest income over the life of the loan with accelerated accretion if the loan is paid off or forgiven. These resulted in an effective yield enhancement of 2.5%. To fund these loans the Federal Reserve is providing in term advances which you can see on Slide 12. These advances allow us to borrow dollar-for-dollar on the PPP loans with fixed rate of 35 basis points. The advances are required to be repaid as forgiveness and payments are received from the SBA or as the borrower repays the loan over the 24-month term. That concludes my remarks. I'll now turn the call over to Chuck.

Thanks Ray, and good morning, everybody. Starting on slide 13, this morning we announced net income of $10.7 million or $0.65 per diluted share for the first quarter of 2020 compared with net income of $11.8 million or $0.72 per diluted share for the first quarter of 2019. Proceeds from a bank-owned life insurance claim and a gain on the sale of a former branch facility increased net income in the prior year period by $1.8 million or $0.11 per diluted share. Excluding the impacts of these transactions, diluted earnings per share increased $0.04 or approximately 7% during the current year first quarter compared to the prior year first quarter. Moving to the slide 14, interest income on loans declined due to the FOMC rate cuts aggregating 225 basis points since the beginning of the third quarter in 2019 with 150 basis points of those cuts occurring in the first quarter of 2020. Interest income on securities benefited from a $1.8 million in accelerated discount accretion from called U.S. Government agency bonds during the first quarter of 2020. In total, interest income was down $0.7 million during the first quarter of 2020 compared to the first quarter of 2019 or down $2.5 million if the accelerated discount accretion is excluded. Interest expense declined in all categories during the first quarter of 2020 when compared to the first quarter of 2019, reflecting the declining interest rate environment. Net interest income declined $0.3 million during the first quarter of 2020 compared to the first quarter of 2019 or $2.1 million if the accelerated discount accretion is excluded. Provision expense totaled $750,000 during the first quarter of 2020, relatively similar to the $850,000 we expensed during the first quarter 2019. We elected to postpone the adoption of CECL as permitted by the CARES Act. As you know, an economic forecast is a key component of the CECL methodology. We are embarking into an unprecedented economic environment whereby a sizable portion of the economy has been significantly impacted by shelter-in-place declarations and similar reactions by businesses and individuals. Substantial government stimulus has been provided to businesses, individuals and state and local governments. Financial institutions have offered businesses and individuals payment relief options. Economic forecasts are regularly updated and there is no economic forecast consensus. Given the high degree of uncertainty surrounding economic forecasting, we have elected to continue to utilize our incurred loan loss reserve model for the time being, updating loss migration calculations and modifying them as necessary to the nine environmental factors at each quarter end. First quarter 2020 provision expense reflects a combination of loan growth, an economic environment allocation change, and a reduction of specific allocations on uncertain fully collected lending relationships. Moving on to slide 15, total fee income during the first quarter of 2020 was similar to fee income recorded during the first quarter of 2019. However, if the aforementioned BOLI claim and former branch facility gain on sale are excluded, fee income during the first quarter increased by $1.8 million or 38%. Mortgage banking income expanded by about 150%, reflecting increased refinance activity during the latter part of the quarter and the successful implementation of several strategic initiatives, including the ongoing hiring of additional mortgage lenders. We also recorded 13% growth in service charge income in large part reflecting a higher treasury management income and 14% growth in payroll processing income due to an expanded client base. On page 16 overhead costs increased $1.1 million during the first quarter of 2020 compared to the first quarter of 2019. Salary and benefit costs were up $0.5 million, reflecting merit pay increases and higher mortgage lender commissions. Occupancy, furniture and equipment costs were up a combined $0.4 million, in large part reflecting the fall of 2019 completion of our main office expansion. On slide 17 reflects that our net interest margin was 3.63% during the first quarter of 2020, unchanged from the fourth quarter of 2019 and down 25 basis points compared to the first quarter of 2019. The previously mentioned accelerated discount accretion on called U.S. government agency bonds had a 22 basis point positive impact on our yield on earning assets and net interest margin during the first quarter of this year. The yield on loans was down 32 basis points during the first quarter of 2020 compared to the fourth quarter of 2019 and down 52 basis points when compared to the first quarter of 2019, in large part reflecting the aforementioned FOMC's aggregate 225 basis point reduction in the targeted federal funds rate. The cost of funds has also been on a declining trend, primarily reflecting the falling interest rate environment, but in terms of magnitude and scale, not to the degree experienced in our yield on loans. Excluding the impacts of the PPP loan and PPPLF programs, we forecast a lower net interest margin during the second quarter of 2020, as we experienced a full quarter impact of the FOMC's aggregate 150 basis point rate reduction in early March and then a relatively stable net interest margin for the remainder of 2020. On slide 18, our mortgage loan originations totaled almost $133 million during the first quarter of 2020, an $88 million or 195% increase compared to the first quarter of 2019. About 65% of the mortgage volume during the first quarter of 2020 consisted of refinance applications compared to only 33% during the first quarter of last year. Approximately 72% of the mortgage loan originations during the first quarter of 2020 have been or will be sold on the secondary market, that's up about 48% from a year ago. The net gain on the sale of mortgage loans was lower during the first quarter of this year, relative to our level of activity, reflecting the onetime impact of our decision to sell closed loans closer to the commitment expiration date, rather than soon after the closing date of the mortgage loan. The accelerated refinance activity did result in a higher level of mortgage servicing right amortization. However, as we use a lower of cost to market methodology, no valuation write-down was recorded. The estimated value of our mortgage servicing rights remains well above the carrying value at March 31. Moving on to slide 19. We remain a strong and well capitalized -- we remain in a strong and well-capitalized regulatory capital position. The bank's Tier 1 leverage capital ratio was 11.3% and the total risk-based capital ratio was 12.9% as of March 31, 2020. The total risk-based capital ratio was over $94 million above the minimum thresholds being categorized as well capitalized. Share repurchase activity during the first quarter of 2020 totaled about 222,000 shares at a total cost of $6.3 million or $28.25 average per share price. In late March we elected to suspend share repurchase activity due to the uncertainty surrounding the COVID-19 environment. We currently have about $10 million available in our current repurchase plan. Turning on slide 20 on some asset quality numbers. The overall quality of the loan portfolio remains very strong with continued low levels of non-performing loans and loan charge-offs. Non-performing loans as a percent of average loans equaled only 12 basis points at the end of the quarter. The balance of other real estate owned was less than $300,000 at quarter end. Gross loan charge-offs totaled less than $100,000 during the first quarter of 2020, while recoveries of prior period loan charge-offs totaled over $200,000. The resulting net loan recovery of about $200,000 equated to three basis points of average total loans annualized. On slide 21, additions in non-performing assets totaled $1.3 million during the first quarter of 2020 in large part, reflecting purchased and peered residential mortgage loans. Due to materiality considerations, loan purchase accounting was in large part discontinued effective January 1, 2020. Therefore, these specific stressed residential mortgage loans are now reported as originated. Moving to slide 22. Due to the high degree of uncertainty that currently exists, we will not be providing earnings performance guidance as we have done on past conference calls. However, we are able to offer key considerations that should be factored into any earnings forecast of our company included in regards to net interest income, the 30-day LIBOR rate; 50% of floating rate commercial loans, or 25% of total commercial loans are tied to this index. We've reprised 30-day LIBOR loans -- based loans on the first business day of each month, equal to the closing rate of the previous month end. And then, hold that rate constant for the entire month. While historically, the 30-day LIBOR rate has approximated the targeted federal funds rate, a credit risk premium, has resulted in an elevated 30-day LIBOR rate. The 30-day LIBOR rate was 99 basis points at March 31 2020 compared to a federal funds rate of 25 basis points. Interest income of commercial loans will be impacted to the degree the 30-day LIBOR rate, fluctuates in future periods. PPP loan and PPP LF volume, PPP loan fundings are in excess of $500 million. SBA loan origination fees totaled in excess of $14 million. Direct loan origination costs aggregate about $1 million. It is likely that PPP LF program will be used to fund a majority of the result in deposit outflows, over the next six to 10 weeks. Net deferred SBA loan origination fees and direct loan origination costs, will be accreted into interest income on loans over the life of the loans on a level yield method. PPP loans are underwritten for a 24-month period. The degree to which PPP loans are forgiven and the loans are effectively paid off by the SBA net deferred loan fee accretion will be accelerated. Accelerated discount accretion on callable U.S. government agency bonds totaled $1.8 million during the first quarter of 2020. Unaccreted discount aggregated $1.5 million, as of March 31. The degree to which discounted agency bonds are called discount accretion will be accelerated. And finally in asset quality and margin, the degree to which an increase in non-accrual loans is experienced loan interest income may be negatively impacted. For provision expense net loan growth requires some level of reserve build via provision expense. The degree to which loans are downgraded, in accordance with our loan grading paradigm reserve building via provision expense may be necessary. The degree to which loans become impaired, due to being placed in non-accrual or TDR status, reserve building via provision expense may be necessary. The nine qualitative environmental reserve allocation factors are formally reviewed at each quarter end. Any changes may have an impact on the required reserve calculation which may impact -- which will impact the provision expense. For fee income, Michigan's shelter-at-home declarations have had a substantial impact, on the home purchase market. The degree to which changes in COVID-19 measures are made by Michigan's Governor are difficult to predict on our mortgage banking operations. Michigan's shelter-at-home declarations have also had a substantial impact on debit and credit card interchange fees as card uses dropped. The degree to which changes in COVID-19 measures are made by the Michigan's Governor are difficult to predict, on our debit and credit card operations. And lastly for overhead costs, Michigan's shelter-at-home declarations have had a substantial impact on various overhead costs such as employee meal and mileage reimbursements as well as foreign ATM fee reimbursements. The degree to which changes in COVID-19 measures are made by Michigan's Governor are difficult to predict on various overhead costs. Any increase in problem loan relationships could result in an increase in collection costs. In closing, while there are many uncertainties that may impact Mercantile's financial condition and earnings performance in future periods, we note that we entered the stressed environment with strong asset quality and capital position. Those are my prepared remarks. I'll now turn the call back over to Bob.

Thank you, Chuck and thank you Ray. That now concludes management's prepared remarks. We'll now open the call up to the question-and-answer session.

[Operator Instructions] Our first question comes from Brendan Nosal with Piper Sandler. Please go ahead.

Hey, good morning guys. How are you?

Good morning, Brendan, fine and you?

Fine, first off I just wanted to thank you at the level of disclosure you guys offered in the slide deck, definitely very helpful. So on questions too, just starting off on the level of the reserve. I get that NPVs are pretty stable. Charge-offs was really benign and you guys talked to delayed CECL implementation. But I guess even so just kind of looking at the level of unemployment claims coming out of Michigan, it seems like it's one of the harder hit states. So just help me square up kind of the relatively stable reserve level versus the stress that we're seeing in the Michigan economy right now.

Yes. Brendan, as we mentioned, as we all know there are so many moving parts to a reserve calculation. And of course now that we have the incurred model as well as the CECL model. And per my comments, my prepared remarks, we thought it best just trying to manage the process and given the massive uncertainty when it comes to the economic forecasting process, which we all know is a significant impact on the calculations within CECL, we thought it very appropriate to continue to use the incurred model. I think it's served us quite well since we performed back in 1997. And yes, it is an incurred model and it definitely starts with migration. But like everybody else has used the model, we do have the nine reserve environmental allocation factors that we're certainly going to consider and we did consider at the end of March and we did make some adjustments. So we will obviously be relying very heavily on those. And then quite frankly, we need to see how this is going – this environment is going to impact our borrowers over the next – especially in the next couple of quarters. And true Michigan has definitely been hard hit. That was already stated by Bob. But we also note that when you look at Michigan's primary presence, those areas have not been as hit hard with most of the cases being in Southeast Michigan. So there's somewhat of a separation there. But obviously, it does affect the economy for the entire state. One of the interesting things with CECL is that upon adoption our day one calculation actually showed a reduction of our reserve of $700,000. So by not adopting CECL at least out of the gates on a day, one calculation we actually increased our reserve so to speak by $700,000. So going forward, we're going to – we understand that there's – that we are entering and are in the midst now of a very stressed environment. And per my comments, we're definitely going to be working with our borrowers, understanding the impact that this is having on them and obviously doing any downgrades that are necessary. Executive management will continue to look at the environmental factors and adjust those as needed given the changes in circumstances involving those allocation factors. We've already downgraded the economic factor to its loss level possible within our current rating paradigm. So I think one last thing as we saw and where that $700,000 reduction in the reserve came from is that over – about 85% of our loan portfolio are commercial loans. So we don't have much of a exposure to the consumer retail area and that what we do have is primarily mortgage lending. When you look at CECL, it's a duration-based model. And with our commercial lending footprint our average duration is barely over two years. That drives – by looking at that by itself that drives a lower level of reserve. So while – when I say the $700,000 reduction would have been taken on day one, that's actually a net reduction. If you actually look at the calculations, our reserve allocations for commercial loans would have fallen much more than that but we did see an increase from our mortgage loans allocation calculations, which resulted in that $700,000. That quite frankly to this management team doesn't make a lot of sense. And unfortunately it's just part of the rules of CECL, where we cannot assume renewals on commercial loans. We have great relationships with many of our commercial borrowers that we expect to have in many future periods, notwithstanding any maturities that they may have coming up in the next few quarters or a couple of years. And then I think lastly and I think really what drove us to not using CECL was the economic forecast aspect to it. We saw the third party that we're going to rely on, primarily for our CECL modeling, change its forecast quite regularly and there were some very dramatic changes that we were going through. So just trying to pick which one of the forecasts we should use was being questioned. One of the other controls that we have as we are building our CECL model was that while we were selecting one third-party provider, we wanted to make sure that that provider was in the range of the consensus that was out there, since as we know there's many folks out there providing economic forecast. We know that there is absolutely no consensus, whatsoever. So one of those key controls that we have in our own model, i.e. make sure that our economic forecasts that we use is in – is within or very close to consensus. It's not because there is no consensus. So we were very troubled to have to start using a brand-new model that we believe has some serious shortfalls in the midst of a very dire crisis that we're in. So a long-winded answer to your question but I want to make sure that everybody understands why we took it. We obviously – certainly did not take it to lower our provisioning expense. We know the banks that have reported so far have reported very significant increases in provision expense. That's fine. We also know that most of those banks have very large consumer loan, retail loan exposures that we saw at least in our own models that we saw the impact that that could have on calculations. And again, being a commercial bank, having this rating paradigm that we've always had adding the nine environmental factors, those are the ones that we're going to continue to rely on. And if we see significant stress within our portfolio or specific credit I should say, we're going to downgrade them accordingly and we'll do our reserve calculations. But it's very, very difficult to understand exactly what the impact it's going to be on asset quality as we move forward just because of the amount of stimulus that has been put in. We have over 1,500 of our clients and more waiting to get PPP loans, which obviously is providing them up to two months of cash flow for some of the biggest expenses that they have. We're also offering our mortgage borrowers payment options that will help protect their cash flows. And even for other commercial borrowers, we're also offering them payment deferral options as well. So, we see significant stress on our entire economy through our marketplaces, but we also see a tremendous amount of stress or stimulus and other variety of programs that are going to lessen the degree that the stress has on our borrowers and on our consumers and commercial borrowers. So, the big question is going to be what is the duration of the impact -- our Governor has been very aggressive on her measures, reflecting the significant impact that it's had especially in Southeast Michigan. No one's arguing that point that those should have been done. But to the degree that we're going to start seeing those lifted if at all over the next few months is going to have by far the biggest impact on our asset quality. And during that time, we're going to continue to measure our portfolio, measure the quality of our loan portfolio and make provision expense entries as required.

All right. Thank you so much for of your thoughts there. I certainly appreciate all of the problems of adopting CECL especially in light of an unprecedented environment. Just a follow up to those comments. If we are on the old incurred loss methodology and kind of credit migration it's such a big component of what provision expense in the open reserves should be, I mean could the actions that you guys have taken and other banks have taken, whether it's forbearance or deferrals, does that slow down the trajectory of migration such that reserve building is pushed out even further as those credits are under a deferral?

Yes. I think one of the things I want -- I should have stressed in my long-winded answer to your first question was that our migration -- our bank and many banks, but our bank has had very minimal losses really over the last five, six, seven years and recognizing that and if you go through our migration calculations, there's a lot of our loan categories where even a grade four or five rate loan would have zero or very, very small allocation to it. What we did a long time ago was we actually adopted minimum or deminimis reserve allocation factors for our five primary categories of commercial loan or five primary segments along with each grade. That was quite a significant increase in the amount of cost if you will or the amount of reserve we were required to carry, as part of our migration. So, our migration numbers were very, very small, but we put in place these deminimis calculations. Quite frankly, that was one of the big differences between our incurred model and our CECL model was that the CECL model did not allow for these deminimis or these minimum reserve allocation factors. And if you look at the decline that I mentioned reserve allocations for commercial loans between incurred and the CECL, it was really the elimination of those deminimis numbers. So obviously, we did not feel comfortable with that because we thought, it was very appropriate to include some deminimis numbers in our reserve calculations, given the very, very clean level of our asset quality of our loan portfolio over the last five to seven years, which obviously was driving a lot of our migration. In regards to your second question here, we're going to continue to work with our borrowers. Our lenders are talking to our borrowers on a regular basis. Based on those discussions, if it's determined that we need to downgrade credits, we're certainly going to do that. But it's just going to take a while for this to shake out of it. So -- and every customer is going to be impacted in a very different way. It's very difficult to do a carte blanch. This is what's going to impact everyone and everyone's going to be treated equally or impacted equally that's just not the case. Especially with commercial lending, I think maybe that can have a little bit better of an impact if you're looking at a retail lending base. But in commercial lending, every single borrowing relationship we have is different and it needs to be looked at on its own merits. That's why we have the grading system. That's why we rely on our grading system to really drive our reserve balance.

Yes. Brendan, this is Bob. I'll add to what Chuck said and just reemphasize what he said earlier that, our loan loss reserve methodology has served us very well over the years during good economic times and under challenged economic times. And we'll see how it all plays out with CECL over the next couple of years as to the adoption and the eventual adoption of that by all banks. But we feel really good about our methodology. We feel really good that our customers are very solid going into this crisis. They were across the board. Portfolio had great strength. Customers are performing very well. I think that will serve them and us very well as we work through this crisis and whatever comes down the road as a result of the shutdown of our economy. So that's very fortunate that we had that strength going in. But as Chuck said we'll continue to analyze each customer and look at their situation understanding where their revenues are coming from and the economy eventually gets reopened here in Michigan. And I think the Governor and all legislators are working on that to make sure that we don't go overboard with the restriction, but make sure that we continue to flatten the curve. And I think the results are showing that that's happening. And I think once that proves to be a sustained pattern then you'll start to see some of the nonessential businesses allowed to be reopened back up and that will bring some certain relief to our customers and customers in our communities that have been shut down. And as a result the unemployment numbers are very high. There's no question about that. When you drive through town parking lots are empty. So you're going to have unemployment. But I think the measures will serve us well. The state will emerge from the crisis. And the county will be reopened and businesses back to work and employees back to work.

All right. Perfect. Thanks for the comment. And then last one before I step back. So on the PPP program $500 million of loans approved so far, looks like the average fee is about 2.8%. So just to make sure I have the math right here. That's roughly $14 million of origination fees that you expect to accrete into NII over whatever the life of the loans ends up being. Is that correct?

That is correct. And then we have about $1 million -- and then we have about -- just to add to that we have about $1 million in direct origination costs that we'll defer and net debt with those fees over the life of loans as well.

Got it. Thank you

Our next question will come from John Rodis with Janney. Please go ahead.

Good morning guys.

Good morning.

Actually my question was just asked and answered on the average fee on the PPP loans. But obviously guys a lot of uncertainty and stuff. But Chuck, just curious and I get all the moving parts and stuff. But when you stress the loan portfolio any thoughts on sort of cumulative losses over the next few years?

No. That's -- we've actually run several different models if you will John. We had our -- back in early 2017, we went through a formal -- we hired a vendor to do a formal stress test of our loan portfolio using the stressed environment that the Fed had set out for the DFAST and CCAR testing that year. And we felt pretty good. It didn't surprise us. The results didn't surprise us when they come back. Given that the loan portfolio hasn't changed much in its makeup and its characteristics, we kind of use those same inputs, if you will and we apply it to our current portfolio. We think that that's a sufficient proxy without having to go through the process and the cost of redoing that. And again we think that's a good proxy because of the ongoing similar characteristics of our portfolio notwithstanding the growth. And as you might expect, we definitely see in both the three scenarios the base case the one and two; obviously, we would see an increase in provision expense. Certainly well and above and beyond an annualization of what we expensed during the first quarter. We're in unprecedented time. So it's so hard to put a scenario out there of saying this is what's going to happen. Hopefully this is going to be a relatively -- the depth of it of the environment are going to be relatively short-lived, per Bob's comments, I won't repeat that. I think he's spot on to how long this crisis is going to impact. And again it goes back and not trying to repeat myself to answer another question, but we're a commercial bank and it's going to impact all of our commercial borrowers in a different way. And quite frankly a couple of our borrowers are having great quarters because they happen to produce products that are very essential during this time. Quite interestingly two of our larger watch list credit are some of our best performing credits we have right now just because of the line of business that they're in. So we can throw numbers at it all day long and I can give you numbers all day long. And this is one of the reasons why we didn't want to go with the CECL methodologies because we wanted to be as quantitative and logical as we possibly could given up the makeup of our loan portfolio. There's no doubt that it's a stressed environment. Companies and individuals are going to suffer. We're going to see an increase in past dues and non-accrual and likely some charge-offs. But the degree of which is just anybody's guess and we can sit around and do scenarios all day long, but it's not going to matter. We're not going to be able to tell today unlike what CECL told us it was going to. What FASB told us was it was going to predict future losses. This environment is just too dynamic, too unprecedented to really have any understanding on April 21 of what the impact is going to be on our bank or any other bank.

No. You're right. It's hard to tell what the new normal is going forward. So just switching gears, Chuck, you said that the margin without specific guidance I think you said -- I just want to confirm. You said you expected it to be down in the second quarter and then sort of stable in the second half of the year. And then just to confirm though when you say down in the second quarter are -- is the right way to think about it down from backing out the discount accretion? So, the sort of the core margin in the first quarter was roughly 3.42% I think. So, down from that level in the second quarter?

Yes. I think -- yes, you're exactly right. That's what my comments were relaying was that we had a core of around 3.40% 3.42% and that we would expect further reduction in the second quarter given the fact that the FOMC rate cuts happened in early March. So, we'd get a full quarter of that. Now, having said that, and again, we can go into lots of different scenarios, a lot of our prime-based loans which is half of our floating rate loans hit their floors at the beginning of March. So, not every loan went down by the 100 and some odd basis points -- 150 basis points that the Fed reduced by. And then, of course, my comments on the 30-day LIBOR that was 99 basis points. We already see that LIBOR coming down this month, which I would have expected with some solidification of the markets that are out there. But again lots of moving parts there, so I didn't really want to give specific guidance there just because of all the moving parts. But yes, I would say there's definitely going to be a reduction of our core margin notwithstanding the PPP program in the second quarter compared to our first. But then I would expect again on a core basis to be relatively steady for the rest of the year once we get out of any major changes in any of the indices that support our loans.

Okay. Makes sense. Okay guys. Thank you and be safe.

Thank you.

Our next question comes from Damon DelMonte with KBW. Please go ahead.

Hey good morning guys. How is it going today?

Hi Damon.

So, quick question for Ray. On the loan growth you saw this quarter in C&I, how much of that was attributable to increased line utilization? And what was line utilization rate last quarter to this quarter?

Yes, Damon, this is Chuck. Of our loan growth, just to kind of back it up a little bit, about half of it was residential mortgage loans basically held for sale portfolio then the other half was net loan growth on the commercial side. I just want to make sure that we got that math right. We saw some increases in line balances towards the end of March, but it wasn't anything out of the ordinary. I don't -- I mean the level of change wasn't anything out of ordinary. We're a commercial bank and we've got lots of lines of credit. So, we see our line balances fluctuating $5 million $10 million $15 million on a day on average. And I would say that while we saw some gradual increases towards the end of the first quarter, it wasn't anything out of the ordinary to what we typically see in a daily basis. And on an overall basis, our line utilization continues to be around 50%. And I would also just stress the fact that our line balances are supported by borrowing formulas. And so while customers may have the need to come in and borrow off their lines of credit and we're more than happy to do so, so long as they're within our borrowing formula. And certainly any slowdown that they may be seeing in their business because of the current environment may have a negative impact on the maximum amount that they can borrow under existing lines. So, again, sorry to say it again but lots of moving parts there. But we have not -- on an overall basis, we have not seen any major spike in line utilization. Of course, $500 million in loan funding to PPP has certainly helped their cash flow situation.

Got it. Okay. And then just to kind of circle back on the PPP. You may have said this and I may have missed this, but the $14 million in fees, obviously, you said $1 million in expenses associated with that. Does that all come in on -- when the loan is originated or is that spread out over the life of a loan? I may have missed that comment.

Yes, we are supposed with emphasis on supposed to get the fee within five days of funding. Although for us we were -- I thought we got to give so much credit to our team in what they've done over the last three weeks to basically work with over 1,500 borrowers and putting the applications through and now we're funding these loans. I think our fundings as of this morning or last night we're up to $485 million. So, we're almost through the initial wave that we've got and we are certainly hopeful that Congress refunds that or put more money into that program because we have more customers waiting. Not $500 million I think we're definitely through the largest amount, but there are other borrowers out there that would like the assistance and we would like to get it to them. What we're finding -- as we find -- what we found getting into the PPP program we're finding getting in the Federal Reserve's liquidity program. And now we're finding -- trying to get our fees is that everyone's trying to figure this out on the fly. So, this is not a criticism of anyone. This is all brand new and everyone's trying to figure it out one step at a time. And so we got through the origination process. Now, we're actually with banks working with the Treasury on getting these origination fees and what type of reporting that we have to provide to them because they don't know the degree that we funded them. They definitely know what we've asked for what our borrowers have asked for and what they have approved. Because the fees are based on when we fund they don't know that. So, now we're finding that there's a reporting mechanism that we need to provide to them that will then initiate them paying us the fees. So, they're supposed to pay it within five days of funding but that assumes that we're providing them that information on that day and there's definitely some catch-up coming with that. Having said all that I would think that we're going to be caught up within the next week or so on that on getting those funds in.

Damon, this is Bob. I want to just pause for a second and follow-up with something that Chuck said. I wanted to give our team here at Mercantile every one on our team's strong thank you and congratulations for being able to work through this PPP process continuing to work through it. We had all hands on deck, you get people from all different areas of the bank regardless of what they did in their regular day job, helping with the process to make sure that we've got these applications in processed entered into the system and approved by the SBA. And we wanted to include some of the comments in our deck just to reflect some of the feedback we have heard from customers that express appreciation some of the things that they heard that were going on at other financial institutions where the process hadn't gone smoothly. And as Chuck said, this is a new process. We're all trying to work through it. But I give tremendous props to the Mercantile team for the work that they did making it as smooth of a process as we could for our clients through some very challenging times for everyone. And I want to just take a couple of seconds to say that because they really deserve it and I can't thank them all enough.

Okay. Great. Well this is another data point as to why community banks are so important to the success of our banking system. So congrats to your team. Just one quick more -- one more quick follow-up question on that. So Chuck, when we think about these fees like have much of them hit in the first quarter? Or do we kind of model in the majority of the $14 million coming in here in the second quarter?

Yes. I mean that's going to be -- the $100,000 question Damon is, we expect -- obviously don't know we've never been through this again. We expect the majority of our borrowers to ask for forgiveness soon after going through their borrowings to pay their salary mortgage payments rent payments and utilities. So when that happens, we would expect that that will be towards the end of May and into June, when they would actually get to that standpoint to that milestone, if you will. So working through the forgiveness, we believe a lot of it will really be a third quarter event. But we definitely would expect that some of that will tail off through the rest of the year. It is 1% financing and I think some of our borrowers will like that and ask for forgiveness later on down the road. We just don't know how they're going to react. We look at ourselves and think okay a majority are going to ask for forgiveness, once they've gotten through the two months of cash flows, but it's hard to know. But my opinion and in doing my internal analysis is that we expect the majority of that to fund through in the third quarter and a little -- most of the rest in the fourth quarter.

Got it. Okay. That's all that I had. Thank you and stay safe out there.

Thank you, Damon.

[Operator Instructions] Our next question will come from Brendan Nosal with Piper Sandler. Please go ahead.

Hey, guys. Just one follow-up for me. On slide 10, you lay out all of the COVID impacted industries. And obviously, it adds up to a decent chunk of kind of the total commercial loan balances. Which of these are seeing the most stress today? And which of these sectors kind of have you guys most concerned as this pandemic plays out over the next few months?

This is Ray. I would say that movie theaters are one key area that we're focused on. They're completely closed and effectively have no revenue. So that will be an area of focus. And restaurants are reduced to drive-thru only in some cases a complete closure and others. So that'll be another. And hotels, hotels lodging are significantly impacted by the inability to move around and travel for business and leisure. So I'd say those three are three key areas.

I will stress though Brendan that as we said earlier, over the years as part of our risk mitigation concentration processes, we look to partner with what we feel are very strong borrowers. And as we commented earlier going into this crisis most of our borrowers were in very solid financial condition and they had the ability to certainly weather the storm probably more so than many other tested clients you could bank in our communities. That said, Ray made some very good points though about businesses are dark right now. And that's why I think people in our state are working very hard to strike a good balance between flattening the curve and reducing the virus, but also making sure that we're not exceedingly harming the economy more than we have to, to accomplish that. So it's a balancing act, but those are all the - we're looking at our entire portfolio because there are some areas that probably the longer this thing goes on we'll have some surprises and some things that will have some unintended consequences from an economic and commercial standpoint, but we continue to monitor the whole portfolio. But we wanted to put this out there for the risk industry that we see are the biggest immediate impact industries of the closures so far.

Yeah, that all makes sense and it's definitely helpful detail. Last one for me. Just looking at new retail payment assistance inquiries, looks like inquiries peaked around the end of March early April then came down. Is that just kind of timing due to when – what payments were due? Is that why that came down? And would you expect inquiries to increase again as we get to the end of April?

I think the way, I would answer that – the way I would answer Brendan is that a lot of people that are either laid off or partially laid off or in some challenged income situation. They want to keep making their payments early and they will – as long as they can. And I think the inquiries at the start were say, hey, what are my options in case I need to go on a payment relief program? And so I think the longer this goes on certainly the more customers you'll have partaking in those pay relief opportunities. So, again, as we said there are a lot of moving parts. A lot of it depends upon the depth of this crisis and the duration of the crisis. And so we've been very pleased with the performance of our clients so far. But certainly the longer it goes on the more they'll be challenged and will also certainly partake more in these relief programs.

Yeah. Got it. All right. Thanks guys. Stay healthy.

Thank you.

This concludes our question-and-answer session. I would like to turn the conference back over to Bob Kaminski, President and CEO for any closing remarks.

Yeah. Thank you, Grant. And thank you all very much for your interest in our company and participating in the call today. We hope you and your families stay healthy and safe. This concludes the call.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.