Mercantile Bank Corporation (MBWM) Q4 2020 Earnings Report, Transcript and Summary

Good morning and welcome to the Mercantile Bank Corporation Fourth Quarter 2020 Earnings Results Call and Webcast. All participants will be in listen-only mode. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Tyler Deur, from Lambert, Mercantile’s Investor Relations firm. Please go ahead.

Thanks, 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 quarter 2020. I am Tyler Deur 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 fourth 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 would like to turn the call over to Mercantile’s President and Chief Executive Officer, Bob Kaminski. Bob?

Thanks, Tyler and good morning, everyone. On the call this morning, we will provide you with detailed information on the company’s performance in the fourth quarter and full year amidst an unprecedented and challenging operating environment as well as an update on continued activities specifically related to the pandemic. As we reflect on 2020, it is paramount that I again applaud the incredible efforts of our dedicated Mercantile team for their immense resiliency and adaptability across the board to navigate the many unique challenges presented from the pandemic throughout the year. As we have consistently stated throughout the pandemic, our focus has been on the health and safety of our employees and customers, which has required flexibility from all team members who have transparently adapted to working remotely and in new environments. The efforts of our entire staff helped Mercantile deliver strong results again in the fourth quarter and throughout 2020 while successfully pivoting with our customers as needed to fulfill their banking needs in a variety of ways. This positivity is reflected in Mercantile’s strong financial performance again in the fourth quarter, with per share earnings of $0.87. Our company’s sustained areas of financial strength allowed our Board to increase our regular cash dividend for the first quarter of 2021 to $0.29 per share. We are pleased to provide a consistent and competitive cash return to our shareholders within this often challenging environment. And after electing to pause stock repurchases in March, we have also reinstated our buyback program during the fourth quarter as a result of our structured framework and prudent focus on maintaining strong capital levels. Chuck will provide further updates on the many moving parts of our financial statements for the quarter end and year-to-date 2020. As mentioned throughout 2020 and across our day-to-day operations, the safety of our employees and customers remains our top priority using the guidelines and best practices of government agencies, including the CDC. While our facilities reopened in late June, growing concern and increased cases in Michigan led us to again close our branches for in-person meetings in November. Our team and clients have adapted seamlessly to alternative methods of banking activity engagement as we continue to closely monitor for developments and revise our plans accordingly. The full timeline of COVID-related activities can be viewed on Slide 10 of our deck. Our lending team’s efforts on the forgiveness phase of the PPP program continued into the fourth quarter as we worked to assist clients with the gathering and submitting of the required information to allow the rendering of a forgiveness determination by the SBA. Additionally, as we entered the early weeks of 2021 with the latest government stimulus package, work on a new round of PPP applications has begun. The efficient efforts of our lending group have been recognized across the marketplace helping to create a new loan and deposit customer relationship opportunities with numerous businesses within our communities that faced challenges in the application process through incumbent banks. Having met the PPP needs of these new clients in the application process, we are now in a position to capitalize on these efforts to grow those relationships. This adaptability has been matched by the perseverance shown within our local economies and we are thrilled to partner with these resilient companies. Our team’s commitment to our markets is illustrated by our engagement with these businesses to further advance our collective work as we strive toward economic recovery and growth. Although our team devoted a significant amount of time assisting both new and existing customers in meeting pandemic-related challenges, we remained focused on identifying and attracting new client relationships and continuing to meet the traditional needs of our existing customers. Ray will provide you with a full update on the performance of our loan portfolio later on this call. Our asset quality remained very strong throughout 2020 as did our unwavering focus on sound credit underwriting, which has led to low levels of past dues and non-performing assets. Our ability to deliver a record-breaking level of mortgage banking income in 2020 reflects our strong residential mortgage loan production and ongoing success of strategic initiatives that we designed to boost market share and increase revenue. Our team has continued their efforts toward ensuring a strong pipeline, and levels remain incredibly solid even through the seasonality of the winter months. We remain focused on positioning ourselves to produce solid mortgage banking income in future periods as evidenced by the opening of mortgage lending centers in Midland, Michigan and Cincinnati, Ohio during 2020. Our lenders have done a magnificent job within a difficult climate and our teams have leveraged opportunities to seize pent-up demand and increase market penetration to enhance revenue achieving strong residential mortgage loan production levels. Again, matching the efficiencies of our teams across the board, our residential mortgage group put forth a tremendous effort to ensure the entire loan origination process from the receipt of an application to closing is completed in a structured and timely manner. And as mentioned earlier in my comments, our diligence and adaptability throughout the year has created significant competitive advantage and opened doors to new and exciting potential relationships. Ray and Chuck will share more detail on this in their comments. Turning to operations, with our ongoing strategic focus on digital delivery in conjunction with branch optimization, we continued to engage our customers through a holistic and personalized approach to their needs as their patterns and preferences of interaction with us are evolving, especially in view of the challenges brought about by COVID-19. The deployment of technology as an alternative delivery channel has been a strategy of Mercantile for many years. We consistently aim to analyze and evaluate our interactions across the board conforming to industry best practices, while leveraging data to best capture efficiencies, customize client engagement, and refine internal systems. Our current footprint and summary of strategic initiatives can be viewed on Slides 3 and 4 of the deck. Our strategic initiatives also demonstrate an ongoing focus on our people and reinforces our commitment to pursuing best practices in environmental, social, and governance with particular emphasis on the social component. Our Board of Directors, which included 2020 introductions of members with diverse business experience, our management team, and all of our employees remain committed to fulfilling their continually evolving roles as purposeful and dedicated community leaders. Throughout 2020, we have expanded our internal diversity, equity, and inclusion programs and facilitated ongoing engagement with guest speakers, whom we have brought in virtually to provide forums for our employees. We have had ongoing purpose-driven discussions within our organization, where staff are able to listen and learn about our community and introspection about themselves as this must be the way of life for us all. Our Management Group, ESG Committee and our entire team are firmly committed to enhancing these sound corporate practices built on integrity and trust, while working diligently to cultivate and strengthen our critical relationships with our diverse communities, our employees, our customers and our shareholders. In late 2020, our team decided that we needed to take some bold action to help address the hunger and shelter crises in our communities. So, we partnered with local nonprofit agencies to invest $100,000 as a direct donation for the purchase of items to help support these basic human needs across our markets. We challenged ourselves as an organization and as individuals for continual involvement, improvement and progress. We set a high bar as we engage our diverse relationships in all facets of our work. We are incredibly pleased with our efforts in 2020 across all levels of our operation as we have built incredible foundations to sustain and continue the development of these initiatives towards the collective future success of all of our constituents. Those are my introductory remarks. I will turn the call over to Ray.

Thank you, Bob. Our total loan portfolio decreased to $134 million during the quarter, including a reduction of our C&I portfolio of $176 million. Both of these reductions were directly impacted by $189 million of PPP forgiveness experienced within the quarter. Owner occupied CRE decreased $20 million. However, non-owner occupied CRE increased by $51 and the mortgage and retail loan portfolios grew by $10 million during the quarter. In general, our C&I loan funding net of PPP activity remains similar to the pre-pandemic levels as we continue to add targeted new commercial relationships around our PPP activity and by serving existing relationships. Additionally, our construction pipeline remains solid with $99 million of commitments in commercial construction and development loans, which we expect to fund over the next 12 to 18 months. Asset quality remains strong as non-performing assets totaled just $4.1 million or 0.9% of our total assets at December 31, 2020. This breakdown can be found in the financial portion of our presentation on Slides 24 and 25. Additionally, accruing commercial pass-through loans at quarter end are nominal in dollar terms, totaling $1.1 million, representing 8 borrowers. Overall pass-through information can be found on Slides 16 and 17. The following recaps our provisioning activities during the COVID-19 impacted time periods. In the second quarter of 2020, provision expense of $7.6 million was generated entirely through increases to environmental factors. The third quarter of 2020 provision expense of $3.2 million was driven by risk rating adjustments to 159 specific credits, 8 of which moved to the watch list. The fourth quarter provision expense of $2.5 million was driven by a $3.9 million increase in qualitative and environmental factors. These actions bring the allowance for loan losses to total loans to 1.33% net of PPP loans, up 49% from 0.84% at December 31, 2019. Payment deferrals at the peak of the program in mid-July impacted 738 borrowers and represented $719 million in exposure. Presently, as of December 31, extensions are in place beyond that date for 18 borrowers representing $14 million of exposure, as seen in Slide 11. The modest current deferral numbers when combined with our expectations for limited future requests and our strong past due performance are positive indicators. The risk rating process depicts a portfolio with strong characteristics, reflecting strength similar to that of the pre-crisis economy as seen in Slide 15. Maintaining accurate risk ratings will remain a key focus in the upcoming quarters as our borrowers continue to report results impacted by the pandemic. We continue to monitor the financial condition and performance of credits, particularly in the following segments, hotels and lodging, assisted living, restaurants and entertainment. None of these individual segments account for more than 5.1% of commercial loans. The composition of these segments can be seen in Slide 13. We recorded non-interest income during the fourth quarter of $14.3 million, up $7 million or 96% from the prior year fourth quarter. As can be seen on Slide 20, this improved level of non-interest income was largely driven by a 200% quarter-over-quarter increase in mortgage banking income, reflecting the success of ongoing strategic initiatives designed to increase market share, a higher level of refinance finance activity stemming from historically low rates, and increased share in the purchase market and an increase in the percentage of loans sold. For the fourth quarter of 2020, purchase mortgage loans originated were up 101% over the comparable quarter in the prior year, while refinance activity increased by 95% as seen in Slide 23. January applications and backlog suggests that refinance opportunities will persist into the near future and purchase applications are at seasonally high levels. 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 as we are able as in the case of our new mortgage office in the Cincinnati area, which opened during the fourth quarter of 2020. Non-interest income from payroll services was flat despite high levels of unemployment during the quarter relative to the prior year comparable quarter and increased 7.4% over the course of the year. Service charges on accounts for the year were also flat due primarily to larger balances offsetting charges. Credit and debit card income increased by approximately 4.8% on a quarter-over-quarter basis as activity within the accounts began to recover from reduced activity during the pandemic and the monthly activity level in December is 16% above the activity level in January, demonstrating the recovery that has taken place during 2020. Finally, we reported $932,000 of swap income reflecting interest rate risk management products introduced and put into place for our clients during the quarter. That concludes my comments. I will now turn the call over to Chuck.

Thank you, Ray and good morning to everybody. As noted on Slide 16 this morning, we announced net income of $14.1 million, or $0.87 per diluted share for the fourth quarter of 2020 compared with net income of $13.3 million, or $0.81 per diluted share for the fourth quarter of 2019. Net income for the full year 2020 totaled $44.1 million or $2.71 per diluted share compared to $49.5 million or $3.01 per diluted share during the full year 2019. Excluding non-core income and expense transactions, diluted earnings per share increased by $0.10 or about 12% during the fourth quarter of 2020 compared to the fourth quarter of 2019, while diluted earnings per share decreased $0.07 or about 2.5% during 2020 compared to full year 2019. Generally speaking, increased mortgage banking income mitigated a lower level of net interest income and higher loan loss provisions during 2023. Turning to Slide 19, interest income loans declined in 2020 periods compared to the 2019 periods primarily 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 rates – of those cuts occurring in the first quarter of 2020. Interest income on securities during 2020 benefited from accelerated discount accretion from called U.S. government agency bonds, totaling $3.0 million during the year. In total, interest income declined $1.9 million during the fourth quarter of 2020 compared to the fourth quarter of 2019 and was down $10 million for the full year 2020 compared to the full year 2019. Interest expense declined in all categories during the 2020 periods compared to the 2019 periods, reflecting the declining interest rate environment. In total, interest expense declined $2.6 million during the fourth quarter of 2020 compared to the fourth quarter of 2019 and was down $7.7 million for the full year 2020 compared to the full year 2019. Net interest income increased $0.7 million during the fourth quarter of 2020 compared to the fourth quarter of 2019 in large part reflect an accelerated PPP net fee income recognition stemming from forgiveness payments from the federal government during the just completed quarter. Net interest income declined $2.3 million for the full year 2020 compared to the full year 2019. Provision expense increased significantly in the 2020 periods compared to the 2019 periods, primarily reflecting the coronavirus pandemic and its impact on the economic environment. Provision expense totaled $2.5 million during the fourth quarter of 2020 and $14.1 million for the full year 2020 compared to a negative $0.7 million during the fourth quarter of 2019 and $1.8 million for the full year 2019. Approximately, 80% of the provision expense recorded during 2020 is reflective of increased allocations associated with qualitative factors, namely economic conditions, loan review and value of underlying collateral dependent commercial loans as well as the creation of a COVID-19 pandemic environmental factor. The COVID-19 pandemic environmental factor developed during the second quarter is designed to address the unique challenges and economic uncertainty resulting from the pandemic and its potential impact on the collectibility of the loan portfolio. The provision expense recorded during the fourth quarter of 2020 was fully reflective of increased allocations associated with the previously mentioned qualitative factors. We have elected to continue to postpone the adoption of CECL as permitted by the CARES Act and the Stimulus bill passed in late December. However, we continue to run our CECL model concurrently with our incurred loss model. Based on preliminary results, the loan loss reserve balance determined by the CECL model is about $2.5 million lower than the loan loss reserve balances determined by our incurred loss model as of year end 2020. Continue on Slide 20, fee income increased in 2020 periods compared to 2019 periods, primarily reflecting significantly higher mortgage banking income. Excluding certain one-time items, fee income during the full year 2020 increased $21.7 million or 92% when compared to the full year 2019. Reflecting increased refinancing and purchase activity, along with the successful implementation of strategic initiatives over the past few years, we delivered mortgage banking income substantially higher during the 2020 periods compared to the 2019 periods. Fourth quarter 2020 mortgage banking income was $6.4 million higher than in the fourth quarter of 2019 and income during the full year 2020 was almost $21 million higher than the full year 2019. Credit and debit card income returned to pre-COVID levels during the third and fourth quarters, reflecting a recovery in transaction volume from the second quarter. While not quite returning to pre-COVID levels, service charge and accounting income during the third and fourth quarters was much improved in the second quarter in large part reflecting higher transaction levels from business customers. Continuing on Slide 21, overhead costs increased in the 2020 periods compared to the 2019 periods, primarily reflecting higher compensation costs and expansion of our main office. Salary and benefit costs were up $1.6 million during the fourth quarter of 2020 when compared to the fourth quarter of 2019. Mortgage banking related compensation costs were up $0.9 million, while the bonus accrual increased $0.4 million. Salary and benefit costs were up $6.0 million during the full year 2020 when compared to the full year 2019. Mortgage banking related compensation costs were up $4.5 million, while base salary costs were up $0.8 million mainly due to annual merit increases while the bonus accrual was up $0.4 million. Occupancy, furniture and equipment costs were up a combined $0.2 million during the fourth quarter of 2020 when compared to the fourth quarter of 2019 and up a combined $1.7 million during the full year 2020 when compared to the full year 2019 in large part reflect in the fall of 2019 completion of our main office expansion. On to Slide 22, our net interest margin was 3.00% during the fourth quarter of 2020, up 14 basis points from the third quarter of 2020, but down 63 basis points when compared to the fourth quarter of 2019. The yield on earning assets increased 10 basis points during the fourth quarter of 2020 when compared to the third quarter of 2020, while the cost of funds declined 4 basis points during the same time period. In comparing the fourth quarter of 2020 with the fourth quarter of 2019, the yield on earning assets declined 106 basis points while the cost of funds declined 43 basis points. The yield on loans was up 31 basis points during the fourth quarter of 2020 compared to the third quarter of 2020, but down 67 basis points when compared to the fourth quarter of 2019 in large part reflecting the FOMC’s aggregate 175 basis point reduction in the targeted federal funds rate during the fourth quarter of 2019 and the first quarter of 2020. We are recording the origination fees and direct origination costs of PPP loans equating to a $15 million net increase in interest income on commercial loans using the level yield method. Fourth quarter 2020 net accretion totaled $5.4 million, an increase of $2.4 million from the level recorded during the third quarter of 2020, reflecting accelerated accretion resulting from PPP loan forgiveness payments received during the fourth quarter. Unrecognized PPP fee income totaled $3.8 million at year end 2020. Based on recent trends, it appears that a vast majority of the remaining PPP loans will be forgiven during the first three quarters of 2021. However, we note that we have received no forgiveness payments on any of our PPP loans exceeding $2 million. Applications for about 70% of the segment have been filed with the SBA. Un-accreted PPP loan fee income associated with this segment equates to about 20% of the $3.8 million still unrecognized. The yield on securities during the full year 2020 benefited from accelerated discount accretion called U.S. government agency bonds Accelerated discount accretion totaled $3.0 million during the year positively impacting the period’s net interest margin by 8 basis points. Negatively impacting our net interest margin during the 2020 period since around mid second quarter was the significant volume of excess on balance sheet liquidity depicted by low yielding deposits with the Federal Reserve Bank of Chicago and a correspondent bank. The excess funds are primarily a product of federal government stimulus programs as well as lower business and consumer investing and spending. Overnight deposits averaged $560 million during the fourth quarter of 2020 and $357 million during the full year 2020 compared to our typical average balance of $50 million to $75 million. We expect the level of overnight deposits to stay at elevated levels well into 2021. This excess liquidity lowered our net interest margin during the fourth quarter of 2020 by about 40 basis points. The cost of funds has also been on declining trend, primarily reflecting the falling interest rate environment, but in terms of magnitude and scale, not to the degree experienced on our yield on loans. As noted on Slide 23, mortgage loan originations increased substantially during the 2020 periods and especially during the second, third and fourth quarters of the year in large part reflecting significant refinance activity stemming from the decreased interest rate environment, coupled with the ongoing success of strategic initiatives that were designed to expand market penetration, enhance gain activities and operate more efficiently. Mortgage loan originations totaled $219 million during the fourth quarter of 2020 compared to $111 million during the fourth quarter of 2019, an increase of almost 100%. Mortgage loans originations totaled $865 million during the full year 2020 compared to $369 million during the full year 2019, an increase of about 135%. About 54% of the mortgage volume during the fourth quarter of 2020 consisted of refinance applications, similar to the level during the fourth quarter of 2019. Approximately 73% of the mortgage loan originations during the fourth quarter of 2020 have been or will be sold on the secondary market also similar to the level during the fourth quarter of 2019. Continue on Slides 24 and 25, our standard quality metrics of loan portfolio remain 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 11 basis points at December 31, 2020. The balance of other real estate owned was $0.7 million at quarter end and consisted almost entirely of former branch facilities. Gross loan charge-offs totaled $0.3 million during the fourth quarter of 2020, while recoveries of prior period loan charge-offs totaled $0.2 million. The resulting net loan recoveries, the charge-offs of $0.1 million equated to 1 basis points of average total loans annualized. For the full year 2020, we recorded loan charge-offs recoveries of $0.8 million. Addition to non-performing assets totaled $1.0 million during the fourth quarter of 2020 with a net decrease of $0.6 million recorded in non-performing assets during the quarter. Over the past 12 months, the balance of our loan loss reserve has increased $14.1 million or about 59% with the coverage ratio, excluding PPP loans growing from 84 basis points, up to 1.33%. As shown on Slide 26, we remain in a strong and well-capitalized regulatory capital position. The Tier 1 leverage capital ratio was 9.8% and the total risk-based capital ratio was 13.8% as of year end 2020. The Tier 1 leverage capital ratio continues to be impacted by the PPP loan portfolio and excess liquidity with no similar impact on risk-based capital ratios as both components are assigned a 0% risk rating. The total risk-based capital ratio was $118 million above the minimum threshold to be capitalized as well – to be categorized as well capitalized. We repurchased about 220,000 shares for $6.3 million at a weighted average cost of $28.25 per share during the first quarter of 2020. After electing to temporarily cease share repurchase activity in March to preserve capital for lending and other purposes due to the uncertainty surrounding the COVID-19 pandemic, we reinstated the buyback program during the fourth quarter and purchased about 14,000 shares for $0.3 million at a weighted average cost of $22.05 per share. We currently have about $10 million available in our repurchase plan. On Slide 27 and to conclude my prepared remarks, due to the high degree of uncertainty that currently exists, we will not be providing earnings guidance as we have done on past conference calls. However, we are able to offer key considerations that should be factored into any earnings forecasts of our company as noted on the slide. Clearly, economic conditions, asset quality, PPP forgiveness activity and mortgage banking operations are expected to have the most impact on our operating results for 2021. In closing, while uncertainties remain that may impact Mercantile’s financial condition and operating performance in future periods, we know we entered the distressed environment with strong asset quality and a solid capital position. We are pleased with our fourth quarter and full year 2020 operating results and financial condition as of year end 2020 and believe we are well-positioned to continue to navigate through the unprecedented environment created by the coronavirus pandemic and other events. Those are my prepared remarks. I will now turn the call back over to Bob.

Thank you, Chuck. That now concludes management’s prepared comments and we will now open the call up for the question-and-answer period.

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

Hey, good morning, everybody. How are you?

Good morning, Brendan. How are you?

Great, thanks. Just wanted to start off on some of the COVID-impacted industries, just hoping you can kind of take us through the state of the hotel, restaurant, and entertainment books today and just how those customers are faring versus the height of COVID last year?

Yes, this is Ray. I will talk about the hotel industry a bit. They are obviously continuing to be impacted very heavily compared to pre-pandemic levels. They are functioning at a higher level than they did earlier in that pandemic from an occupancy standpoint, focusing a lot on expense reductions and the like. Our portfolio has performed quite well. We have a very strong sponsor group amongst the portfolio, which has helped sustain those particular assets and has the ability to continue to do that. We feel like we have got them well positioned in terms of the structure, the AMs, and the like. We have had a number of the operators bringing additional capital to the table to reduce our loans, which has been well received by us and shows the commitment of those operating groups through those assets. So, the most direct answer to your question is that they are slightly improved over where they were at the depths of the pandemic.

Yes, that’s helpful color. Thank you. And then one more from me, just thinking about kind of reserve coverage as we were at the start of the New Year here, I found it interesting that your CECL reserve hypothetically was actually lower than the incurred loss reserve base today. So, just curious as you kind of look at the outlook for the year, do you see much more of a need to continue building reserves or based on what you know today, do you think you are at a sufficient level?

Yes. Brendan, this is Chuck. I will take the first stab at that. And as I mentioned in my prepared remarks, 80% of our provision that we did in 2020 was due to the environmentals. And as you saw from our metrics, we are continuing to have very strong asset quality, and we have been able to build the reserve based on those environmentals not so much so on specific credit deterioration, which, as Ray mentioned, most of that took place with our extended review during the third quarter. As long as those quality numbers stay consistently strong, the ability to grow your reserve continues to primarily rely on the environmentals. So, it seems to us that if we continue in the pattern that we are doing that our provision will certainly be much lower than it was in 2020 and so knock-on wood that we can continue to do that. But again, we continue to have our loan review program, all the communications that we have internally. Clearly, we have very closed eyes on the credits. On all credits, but certainly those that are in the industries that are – have been most heavily impacted, and I don’t think we would be surprised anyone saying we have regular contact with those borrowers. So overall, we feel pretty good. In regard to specifically with CECL, I think we – this is my opinion, we started to see it last week, late last week with the mega banks reporting and talking with other CFOs – bank CFOs, I think one of the common themes that’s out there with the CECL models is that the economic forecasts are starting to improve, and that was one of the – our CECL model throughout 2020 was much closer to our incurred model. The $2.5 million or so that we see at year end 2020 was quite a bit higher than – difference was quite a bit higher than what we are seeing. And most of that was because of the economic forecast improvement. Like most banks, we certainly used a third-party as our primary source, but also have another third-party that we throw into the model as well just a test to make sure that the models we are using are somewhat similar or in consensus with the markets that are out there, and the reserve allocated for the economic factor fell quite dramatically. So, I think that, that might be a trend that we see, we will see over the next couple of weeks. But with – and I think that makes sense from the CECL standpoint is we saw a lot of build taking place earlier in 2020 because of the segregation of economic environment and the forecast, but now with the economic forecasts coming out better with improved results, those using the CECL model or because of the CECL model, it does result in some reserve release. And of course, what you do overall, it depends on all the other factors and calculations that go into it.

Perfect.

Yes, this is Bob. I would say that as we have talked about in past calls, we have years and years of experience with the incurred loss model and we feel very comfortable with the levels of reserve that it requires us to have during all kinds of economic conditions, whether it be challenging times such as we experienced in 2020 or good economic times. And we think that, as Chuck said, that’s the best way for us to have a good solid reserve that reflects the risk in the portfolio and keeps us where we need to be. And just as we have throughout other economic cycles in the past, we will continue to evaluate, we will continue to look at the qualitative factors and obviously look at our credit relationships and making sure as we always do that the risk ratings are accurate and where they need to be as well. And we will do that obviously in conjunction with what we are seeing on the parallel CECL model. Because as Chuck said, there is some interesting dynamics that take place based upon what that model is based on. And – but we will take all that into consideration and continue to make the evaluation of each quarter as to where the reserve needs to be, but we feel really good about where it’s currently at and the process that we have to make sure it stays there.

Excellent. Thank you for taking my questions.

You bet.

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

Good morning, guys. How are you doing today?

Fine, Damon. How are you?

Doing great. Thanks. So, first question, Chuck, just wanted to talk a little bit about the margin, can you – I think you had said how much the PPP loan forgiveness on a dollar basis was. Could you just repeat that and do you know what that was off the top of your head from a basis point standpoint?

Yes. Let me catch up to myself here. The growth was about 2 to 3 – if you compare fourth quarter over third quarter, the increase in the fourth quarter is about $2.3 million or $2.4 million higher than what we did in the third quarter. And a vast, vast majority, if not, all of that was related to the forgiveness payments and the acceleration on the fee income that took place as a result. We got our first forgiveness payment I think it was October 30, whatever the last business day was of October and then they have been since that time pretty regular as far as a pretty wide range, we get somewhere between $2 million to $6 million a day in that and that has continued here into January. On a basis point that $2 million to $3 million – $2.4 million added about 25 basis points to our margin for the quarter. So, we got – the way I look at it, we got a 25 basis point improvement because of that and then as I mentioned about a 40 basis point negative impact to our margin because of the excess liquidity, so not that would put us at about a 3.15% if you will, core margin and that’s pretty similar to what we have talked about on past calls.

Got it, okay. And then you had said that you expect the majority of the remaining forgiveness to occur in the first three quarters, was that accurate?

Yes, I would probably say first two quarters. Hopefully, that’s what I said. I know that’s what I had in my script, first two quarters. The ones under $2 million continue to come in. Of course, we have to wait for the borrowers to put their applications together, we review it then we submit it to the SBA and then of course, wait for the SBA to do what they need to do before they send us to ACH. So, we have a pretty small part, as far as the timing of all that goes. But like I said, it’s been pretty regular, steady on the amount of forgiveness that we have got coming through. So based on what we saw the last 2 months and as well as what we have seen so far here in January through the first 2 weeks, I would expect that most of those will be paid off by the end of the second quarter. Again, I threw that out there, on the $2 million, we’re just not sure what the government is doing with that segment, clearly on, way back in the second quarter. They indicated loans that were over $2 million were going to get additional scrutiny. It certainly appears that way. The application – forgiveness application process and the application itself is much, much more long – is much more longer, much more evolved. We have instances where they’re asking for additional information on some of them. So it’s definitely taken a longer time period than what we see with those loans under $2 million. So it’s a guess that it’s going to be at the end of the second quarter, feel pretty confident about those that are under $2 million and we’re hopeful that the government will start accepting or approving the forgiveness applications and paying off those over $2 million as well. As of year-end, the over $2 million portfolio was about 50% of our outstanding balance. So it’s about $185 million in that segment. So it’s a pretty large segment on the balance sheet. The forgiveness – the net origination fee is about 20% of the, I think, $3.8 million left.

Got it, okay. And then on expenses, obviously you got some good cost savings from those branch closures. What do you feel is a reasonable core run rate that we should actually model from this point forward going into 2021?

Yes, I kind of threw the word core with the word normal just trying to figure out where we’re at. There were some additional – we don’t talk about them, but there were definitely some costs in there related to PPP, stay-at-home, work-from-home costs in there. But I would say, if you get down to the core, I would say that the increase in 2021 from 2020 will be somewhere between 1.5% and 2%.

Okay. And that would be off of like call it $98 million or so $98.5 million or no?

Yes, I don’t have that number in front of me, Damon, but whatever gets down to the core that we threw in there, I think, that’s a pretty good guess.

Okay. And then just one – well, two quick ones here and fee income – the swap fee income that you guys broke out this quarter, is that something that – is that kind of a new focus for you guys where we should start to incorporate a measure of that each quarter or is that more of a one-time?

No, it’s definitely a new program and it’s a back-to-back swap program. Clearly, a lot of banks have been doing this. What it is, it’s a way to manage interest rate risk from, what I would call, our longer term commercial loans. So those are typically 5-year balloons. Occasionally we do 7-year balloons. Historically, we use the FHLB and, to a lesser degree, the broker deposit program to kind of match-fund those. But clearly what we’ve seen – as why we continue to book the 5-year fixed rate balloons and the occasional 7-year, we certainly don’t need to go to the FHLB and get advance money. So what we have found, it started really in 2019, but certainly throughout 2020, is we really didn’t have the ability from an on-balance sheet standpoint to really effectively hedge those longer term fixed rate commercial loans. So we started to explore the opportunity to do swaps with certain customers. It’s not going to be something that we go out there with all customers, but generally are those that are of larger size and of sufficient sophistication. We want to make sure that we treat this program delicately because when you introduce a swap to many borrowers, not all, but many borrowers, it is a new tool for them and we do have a third party – a well-known third party that we’ve hooked up with as an advisor. They not only help us directly, but also has interaction and materials for our borrowers as well. And so what this is, is for identified borrowers, again, there will be larger balanced, more sophisticated borrowers instead of – historically, we offer all of our borrowers a fixed and floating rate. What we’ll do going forward on these particular borrowers is we will only offer them a floating rate. If they want to go fixed rate, they will enter into an interest rate swap with the bank directly to get on the fixed rate. Of course, that gives us what we don’t want, have some fixed rate again. So we immediately, simultaneously, go to a correspondent bank and enter into the opposite swap. So the swap exposure is basically nil, just some remnants of some credit exposure there, which of course we underwrite that with our borrowers, as part of our underwriting loan to – adjusted loan to collateral values. And because of that, we’re able to – because of the difference in rates, we’re able to get some upfront fee income activity. So again, I’m sure this is common with many of your banks. So it’s a program that we rolled out in the fourth quarter. It’s a program we’ll continue to go with. It is going to be a transactional-type activity. So my guess is that some quarters will be larger in fee income and others will be lower in fee income, but I would say somewhere between – our budget, to be honest, is about $50,000 to $70,000 a month is what we have been budgeting there. Again, it’s pretty new for us, of course, but we certainly see the opportunity and quite frankly the need to do this to manage that longer interest rate risk exposure.

Got it. Okay, that’s great. And then if I could squeeze one more quick one in for Bob, any thoughts on the recent TCS sale to Deutsche Bank and possible follow-up from there? I think there might be some branch divestitures coming and maybe your thoughts on that and possibly picking up some – maybe new lenders? Thanks.

Well, as we talked about in the past, wherever there is disruption that may be caused – if there’s a bank M&A type of transaction in any of our markets, it does provide some potential opportunities, and like we have in the past, with this particular one that you referenced, we’ll continue to look and see if there is any way for us to strengthen ourselves because of some of the transitions that are taking place in the marketplace for those banks. So we will continue to take a long look at any opportunities that come down the pike and make the best decisions from a strategic standpoint for Mercantile. And it seems like whenever there is disruptions, customers usually end up experiencing some frustrations and some issues like that as well as some employees as well. So we’ll keep our options open and keep looking to see what the opportunities may avail themselves to us as we all go through the next several quarters.

Great, thank you very much for taking all my questions this morning.

You bet. Thank you, Damon.

Our next question will come from Bryce Rowe with Hovde. Please go ahead.

Thanks. Good morning.

Good morning, Bryce.

Good morning, Bryce.

I appreciate you taking the questions here this morning. I had a – had one on kind of the mortgage commentary that you offered, sounded like you have got a good outlook in terms of mortgage despite some of the higher 10-year rates that we’ve seen over the last month. So maybe you could help us think about the mortgage market share takeaway relative to what kind of current market volumes might be reflective of higher 10-year rates?

Yes, this is Chuck. I’ll take the first stab at that and let Bob and/or Ray comment on that. I think, trying to forecast mortgage banking is certainly very, very difficult, especially in regards to the refinance activity. I think market data, kind of what we’ve seen from third parties is that, maybe up to a third of mortgage borrowers up there have the opportunity to refinance and of course that’s going to change almost every day as mortgage rates change. But clearly, mortgage rates continue to stay relatively low and there are some opportunities out there. We certainly expect that rates probably won’t go any lower, if any – if anything, maybe a little bit higher as you mentioned, Bryce. So we certainly don’t – are not anticipating that refinance activity in 2021 will be that as it was in 2020. So net and refinancings, we’re expecting less income from that. So this is something we want to focus on all the time, but I think this period of time really focus is on the fact that in a mortgage banking program, you got to make sure that you’ve got the ability to make mortgages on the purchase side. It’s great to make a lot of fee income when rates decline and everybody has the opportunity to – or most of them have the opportunity to refinance. But to keep a strong operation and to keep it going, you really have to have a solid lender base that has the appropriate contacts that can make sure that we get our share, if you will, or the purchase mortgage market. And that is something that we definitely concentrate when we’re talking to potential new lenders coming on board. It’s looking at their experience, their expertise, their history in regards to that purchase market. So as part of the strategic initiatives that I mentioned, I think, Ray mentioned as well, we’re certainly growing that not just new offices like Midland and Cincinnati last year, but also adding new lenders to us in our existing markets as well. So we’re going to continue to look for opportunities. In our current markets, we’re definitely going to continue to look at other markets, adjacent markets or other opportunities that come up to add to the team. So that will help on – we believe will definitely – expectation would be that, that will help us on the purchase side. So, net, where does that fall, it’s really almost impossible the tell, but I think the net overall aspect is, as we expect a decline in refinance to some degree, but we would expect given the current market’s, both economic and interest rate that we’ll see a pickup in purchase activity. So a long answer, but I didn’t give a specific answer too, but that’s how we look at it.

Okay, go ahead.

A bit of additional color would be that since the turning of the calendar to 2021, our pipeline has gone up about 20%, which would not be seasonally expected and it’s maintained its proportions as it relates to refinance and purchase. So, both forces are still in effect and very strong both seasonally and in absolute terms. So, whatever the correct number of people is out there or proportion of people that can benefit from refinance that pool still exists and they are still actively pursuing that. And we have definitely seen that on a rather consistent basis from the first of the year till now.

Okay, that’s helpful, Ray. I appreciate it. I wanted to ask, I guess, a question, I got two more questions, one around PPP any indication from borrowers on this latest round of the PPP in terms of how much interest there might be here in 2021?

Yes, it’s interesting. In the first go round, we had over 2,000 loans for $550 million during the course of that program. We are just getting started. We already have 300 applications that we have received to the tune of about $75 million. So, the interest out of the gate was pretty strong. It’s toned down a bit already. And so how the past will be going forward from a trajectory of applications and apps approved remains to be seen. Our sense is that it will be somewhat less and to what degree, it’s way too early to tell, but that’s the current as of yesterday morning data.

Okay. That’s helpful. And interesting commentary around forgiveness of these loans with $2 million or more in balances, guys, I am curious, what’s the reaction from those borrowers with maybe more scrutiny being placed on the forgiveness process. I mean, I don’t know how much involvement you have had with those particular customers, but if you have any kind of anecdotal commentary that would be interesting?

Honestly, I have had very limited conversations about that. They are just anticipating what’s coming next, reading everything that they can find and trying to offer information that will support the activity that they undertook in the program, which they all to a person believe was appropriate. And they are just looking forward to the opportunity to lay out whatever information needs to be provided to make that case.

Okay. That’s helpful. And then maybe last one for me here, lot of talk about loan yields and the impact from the PPP and forgiveness as well as some commentary around the excess liquidity. I was wondering with, I guess, the economic outlook possibly having gotten a bit better here as we move into ‘21, what are competitors doing from a – maybe a loan pricing perspective now relative to what it look like in the heat of the pandemic. I am just kind of trying to understand if there is pricing pressure coming down the pike in ‘21 relative to what we might have seen last year? Thanks.

I have not really witnessed or experienced or felt any additional pricing pressure that has happened in the time periods that you referenced. I would say there is pricing pressure, but it hasn’t really changed.

Okay, that’s very helpful. Thank you all.

Thank you, Bryce.

This will conclude our question-and-answer session. I would like to turn the conference back over to Bob Kaminski for any closing remarks.

Thank you, Grant and thank you all very much for your interest in Mercantile Bank Corporation. We hope that you and your family stay healthy and safe. And we look forward to speaking with you again at the conclusion of the first quarter in April. This call is now concluded.

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