Nichole Kladder; First Vice President and Chief Marketing Officer; Mercantile Bank Corp
Raymond Reitsma; President, Chief Executive Officer, Director; Mercantile Bank Corp
Charles Christmas; Chief Financial Officer, Executive Vice President and Treasurer of Mercantile, and Executive Vice President and Chief Financial Officer of the Bank; Mercantile Bank Corp
Brendan Nosal; Analyst; Hovde Group, LLC
Daniel Tomayo; Analyst; Raymond James Financial, Inc.
Nathan Race; Analyst; Piper Sandler Companies
Damon DelMonte; Analyst; Keefe, Bruyette & Woods, Inc.
Operator
Good morning and welcome to the Mercantile Bank Corporation 2024 second quarter earnings conference call. (Operator Instructions) Please note this event is being recorded. I would now like to turn the conference over to Nichole Kladder, First Vice President, Chief Marketing Officer of Mercantile Bank. Please go ahead.
Nichole Kladder
Good morning, and thank you for joining us. Today we will cover the company's financial results for the second quarter of 2024. The team members joining me this morning include Ray Reitsma, President and Chief Executive Officer; as well as Chuck Christmas, Executive Vice President, Chief Financial Officer.
Our agenda will begin with prepared remarks by both Ray and Chuck and will include references to our presentation covering this quarter's results. You may access a copy of the presentation as well as the press release published earlier today by visiting mercbank.com.
After our prepared remarks, we'll then open the call to your questions. Before we begin, 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 factors described in the company's latest Securities and Exchange Commission's filings. The company assumes no obligation to update any forward-looking statements made during the call. That is all I have for you today. I will now turn the meeting over to our President and Chief Executive Officer, Ray Reitsma. Ray?
Raymond Reitsma
Thank you, Nichole. My comments will focus on our loan-to-deposit ratio, deposit growth, loan growth, asset quality, and net interest income. Over the last three years, commercial loan growth and mortgage loan growth has been strong. And while our deposit growth has been solid, it has not kept pace with total loan growth.
As a result, the bank's loan to deposit ratio increased to 110% at year-end 2023 compared to 85% at year-end 2021 when deposits were elevated because of the PPP program and the resulting excess liquidity in the system. We believe the bank's elevated loan-to-deposit ratio is a contributing factor to our below peer valuation despite a strong return profile.
Following comments summarize the strategies we believe will contribute to further reductions in our loan-to-deposit ratio. We have undertaken a three-pronged approach to building our deposit base with the objective of reducing the loan-to-deposit ratio into the mid-90% range over time.
First, we plan to grow in the public and municipal realm through strategic personnel additions with existing relationships in this space. Second, placing additional focus on small business banking through more efficient underwriting and obtaining the full relationship that characterizes this type of business.
Third, growing the retail customer focus based on total balances as opposed to activity hurdles, such as transactions and card usage. These efforts led to an increase in local deposits in the first half of 2024 of approximately $260 million, a 14% annualized growth rate.
Local deposits grew $153 million in the second quarter alone. Mortgage loans on the balance sheet have grown substantially over the past few years as borrowers have opted for ARMs rather than fixed rates and the increasing rate environment. We have successfully executed changes within our portfolio mortgage programs resulting in a greater portion of our mortgage production being sold rather than placed on our balance sheet.
The positive outcomes include a 76% increase in mortgage banking income during the first six months of 2024 compared to the respective 2023 period and a nominal increase in mortgage loans on our balance sheet of $12 million year to date.
Commercial loan growth in the first half of 2024 was $118 million or 7% annualized. The current pipeline stands near the trend line established over the last three quarters, including commitments to fund commercial construction loans of $320 million and residential construction loans of $37 million.
Customer reductions and loan balances from excess cash flow or asset sales of $76 million also impacted our commercial loan totals. Taking these factors into account, we do not expect to see a deceleration in commercial loan growth in the immediate future.
Taking together, these strategies produced a loan-to-deposit ratio of 107% as of June 30, 2024, compared to 110% at year-end 2023, as deposit growth was approximately double total loan growth year to date. This ratio reduces to 102% when giving effect to our sweep account balances. During this period, the ratio of wholesale funds to total funds decreased from 13.8% to 12.1%, another demonstration of the strengthening of the funding side of the balance sheet.
Asset quality remains very strong as non-performing assets totaled $9.1 million at quarter end or 16 basis points of total assets, consisting of 25% residential real estate and 75% non-real estate commercial loans. There is no commercial real estate representation among the non-performing assets. Past due loans [in dollars] represent 14 basis points of total loans and there is no outstanding ORE.
Non-owner-occupied office exposure is $271 million or 6% of total loans. The borrowers in this asset class have performed well and continued to be monitored closely. We remain vigilant in our underwriting standards and monitoring to identify any deterioration within our portfolio. Our lenders are the first line of observation and defense to recognize areas of emerging risk.
Our risk rating model is robust with a continued emphasis on current borrower cash flow, providing prime sensitivity to any emerging challenges within a borrower's finances. That said, our customers continue to report strong results to date and have not begun to experience impacts of a potential recessionary environment in any systemic fashion.
Total net interest income grew 40% during the first half of 2024 compared to the first half of 2023, with growth reported in virtually every category. Mortgage banking income grew 76% based on the strategies outlined earlier and the resulting ability to sell a greater portion of the originations on the secondary market.
Income from interest rate swaps grew 18% as we met our customers' desire for fixed-rate financing, principally in the CRE market. Service charges on accounts grew 58%, reflecting higher activity levels and customer growth and less earnings credit offset to charges based on reduced balances in transaction accounts. Payroll Services grew by 20% as our offerings continue to build traction in the marketplace.
Finally, credit and debit card income grew 4% when adjusted for the receipt of a onetime payment from Visa associated with our contract renewal in the second quarter of 2023. That concludes my comments. I will now turn the call over to Chuck.
Charles Christmas
Thanks, Ray. Good morning to everybody. This morning, we announced net income of $18.8 million or $1.17 per diluted share for the second quarter of 2024 compared with net income of $20.4 million or $1.27 per diluted share for the respective prior year period.
Net income during the first six months of 2024 totaled $40.3 million, or $2.50 per diluted share compared to $41.3 million or $2.58 per diluted share during the first six months of 2023. While non-interest income increased during both periods, net income was negatively impacted by higher provisions for credit losses and increased non-interest expenses. Net interest income was relatively similar.
Interest income on loans increased during the second quarter in first six months of 2024 compared to the prior year periods, reflecting the increased interest rate environment and solid growth in commercial and residential mortgage loans.
Our loan yields during the second quarter of 2024 was 45 basis points higher than the second quarter of 2023, with average loans up about 9% over the respective periods. The improved loan yield largely reflects the combined impact of an aggregate 75 basis points increase in the federal funds rate during the period of March through July of 2023 and over two-thirds of our commercial loans having a floating rate.
Interest income on securities also increased during the 2024 periods compared to the prior year periods, reflecting growth in the securities portfolio and the higher interest rate environment. Interest income on interest earning deposits, a vast majority of which is comprised of funds on deposit with the Federal Reserve Bank of Chicago also increased during the 2024 periods compared to the prior year periods, reflecting a higher average balance and an increased yield.
In total, interest income was [$13 million and $29.2 million] higher during the second quarter and first six months of 2024, respectively, compared to the prior year periods. We recorded increased interest expense on deposits in our sweep account product during the second quarter and first six months of 2024 compared to the prior year periods, reflecting the increased interest rate environment, money market, and time deposit growth, transfers of deposits from no or low cost deposit products to higher cost and deposit products and enhanced competition for deposits.
Our cost of deposits during the second quarter of 2024 was 106 basis points higher than the second quarter of 2023, with average deposits up almost 13% over the respective periods. Interest expense on the Federal Home Loan Bank of Indianapolis advances also increased during the 2024 period compared to the prior year period, generally reflecting the higher interest rate environment as well as a higher average advance portfolio balance in the year to date comparison.
Interest expense on other borrowed funds increased during the 2024 periods compared to the prior year periods, primarily reflecting the higher interest costs of our trust-preferred securities.
In total, interest expense was $13.4 million and $30.7 million higher during the second quarter and first six months of 2024, respectively, compared to the prior year periods. Net interest income declined $0.5 million and $1.5 million during the second quarter and first six months of 2024, respectively, compared to the prior year time periods.
Our net interest margin declined 42 basis points during the second quarter of 2024 compared to the second quarter of 2023. Although our yield on earning assets increased 46 basis points during that time period, our cost of funds was up 88 basis points.
While we experienced rapid growth in earning asset yields during the period of March of '22 through July of '23, when the FOMC raised the federal funds rate by 525 basis points, meaningful increases in our cost of funds did not begin to materialize until the latter part of 2022, when competition for deposit base balances increased deposit rates and depositors began to move funds from no and lower-costing deposit types to higher costing deposit products.
Our net interest margin peaked during the latter part of 2022 and early stages of 2023. Impacting our net interest margin more recently is our strategic initiative to lower the loan-to-deposit ratio, which generally entails deposit growth, exceeding loan growth and using the additional monies to purchase securities.
A large portion of the deposit growth is in the higher cost in money market and time deposit products, while the purchase securities provide a lower yield than loan products. We recorded a provision expense of $3.5 million and $4.8 million during the second quarter and first six months of 2024, respectively.
The second Quarter 2024 provision expense primarily reflects a specific allocation for a non-performing, non-real estate related commercial loan relationship and allocations necessitated by net loan growth. The first six months expense also includes a specific allocation recorded during the first quarter of 2024 for a different non-performing, non-real estate related commercial loan relationship.
Non-interest expenses were $1.9 million and $3.3 million higher during the second quarter and first six months of 2024, respectively, compared to the prior year time periods. The increases largely reflect higher salary and benefit costs, including annual merit pay increases, market adjustments, higher residential mortgage lender commissions, lower residential mortgage loan deferred salary costs, and increased medical insurance costs.
Higher data processing costs also comprise a notable portion of the increased non-interest expense level, primarily reflecting higher transaction volumes and software support costs, along with the introduction of new cash management products and services. We remain in a strong and well-capitalized regulatory capital position.
Our bank's total risk-based capital ratio was 13.9% at the end of the second quarter, slightly over $200 million above the minimum threshold to be categorized as well-capitalized. We did not repurchase shares during the second quarter of 2024.
We have $6.8 million available in our current repurchase plan. While net unrealized gains and losses in our investment portfolio are excluded from regulatory capital calculations, we do regularly compute our regulatory capital ratios, assuming the calculations did include debt adjustments. While our regulatory capital ratios were negatively impacted by the pro forma calculations, our capital position remained strong.
As of June 30, our Tier 1 leverage capital ratio declined from 12.2% to 11.3%, and our total risk-based capital ratio declined from 13.9% to 12.9%. Our excess capital as measured by the total risk-based capital ratio was also negatively impacted. However, it's still a strong $150 million over the minimum regulatory amount to be categorized as well-capitalized.
On slide 22 of the presentation, we share our latest assumptions on the interest rate environment and key performance metrics for the remainder of 2024, with the caveat that market conditions remain volatile, making forecasting difficult.
This forecast is predicated on the federal funds rate being lower by 25 basis points effective October 1. We continue to project loan growth in the range of 4% to 6%. We are forecasting our net interest margin to be in a range of 3.50% to 3.60% during both the third and fourth quarters.
We expect increased interest costs from continued growth in higher cost in money market and time deposits and the renewal of maturing time deposits open and lower interest rate environments to be generally mitigated by the renewal replacement of maturing fixed rate commercial loans and investments that were made and obtained in considerably lower interest rate environments. We expect non-interest income and non-interest expense to be relatively stable during the remainder of 2024.
In closing, we are very pleased with our 2024 operating results and financial condition and believe we remain well-positioned to continue to successfully navigate through the myriad of challenges faced by our financial institutions. Those are my prepared remarks. I'll now turn the call back over to Ray.
Raymond Reitsma
Thank you, Chuck. That concludes the prepared remarks from management. We will now move into the Q&A portion of the call.
Operator
(Operator Instructions) Brendan Nosal, Hovde Group.
Brendan Nosal
Hey, good morning, Ray and Chuck, how are you guys doing?
Raymond Reitsma
Doing well.
Brendan Nosal
Maybe just starting off on deposit competition and what you folks are seeing there, I mean, it's still like the mix shift out of non-interest-bearing has slowed pretty materially and the pace of increase in deposit pricing has as well. And so just kind of curious where the competitive environment stands and how much further bleed in funding costs you might see as the year progresses?
Charles Christmas
Yeah, Brendan, it's a good question. This is Chuck. I would agree with your comment that transfers from the no or low costing deposit products has definitely slowed from certainly from where it was in the back half of last year and the beginning of this year. We still see some of that, but certainly not as what we had before.
One of the things that we haven't seen that we typically do it kind of goes back to in January of each year, we lose quite a bit of non-interest bearing deposits as our commercial customers, pay bonuses, taxes, and partnership distributions. And then we generally see that ramp back up and kind of go through the same cycle again.
We're not seeing the growth in non-interest bearing accounts that we typically would. But what we are seeing is those businesses growing their money market and in some cases time deposits. So I think with the rates being higher than obviously what they have been over the last few years, I think our commercial customers are being more savvy and pay more attention to cash management. And so that's increased. So our margin or net interest income is impacted by them putting money into those higher money-market accounts versus the non-interest bearing accounts.
I would say that interest deposit rates in our markets have remained relatively stable for the last few months, which obviously is a good thing. I think you know, we're still feeling that the rates are relatively high in total, but we're not seeing them increase anymore.
Brendan Nosal
Yeah, that's a helpful color, Chuck, thank you. And maybe one more for me before I step back. Just on that goal to get the loan to deposit ratio into the [mid-90s] over time. I know that there's a lot of factors environmentally that can kind of help or hurt that. But just kind of curious on how you think about a timeframe to get towards that target.
Raymond Reitsma
Because of the way you opened your question, we don't think about it with a timeframe. You're correct, there are so many variables and our goal in general is to continue to grow the loan portfolio at a pace that our markets and customers demand of us and outgrow that with deposits at the same time.
And to do that without going above market for deposit rates, so those are the factors that will determine how quickly we can bring it down. And for the first six months of the year, we've been able to grow our loan book at about 7%, deposit book at about twice that at 14%. And so that's an indication of what the last six months environment yielded.
We don't expect that to change materially. But as we've seen financial markets, things do change and they will. So we'll have to adjust as that happens.
Brendan Nosal
Yeah, fair enough. All right, thanks for taking the questions.
Operator
Daniel Tomayo, Raymond James.
Daniel Tomayo
Hey, thanks, guys. Good morning. Just digging into credit a little bit. It's obviously been a strength for you guys and remains so. But just curious if you're able to give us any information on the commercial relationship that drove the increase in reserves in the quarter.
Raymond Reitsma
Well, it was an outlier. It was a non-real estate related. Our C&I business did basically ran into management issues and that caused the credit issue. Doesn't look like it relates to anything systemic in the marketplace, the economy, or our portfolio.
Daniel Tomayo
Okay. And was taken in terms of reserves on that loan, where does that stand in terms of loan due -- I'm sorry, in terms of coverage?
Raymond Reitsma
We reserved it aggressively and fully, so wouldn't expect to have further reserve related to that credit.
Daniel Tomayo
Okay, great. And then I guess you had the classified and criticized trends, anything noteworthy may not be fully up to speed on those yet, but just curious if -- from what you guys know now like what we can expect when the right data comes up.
Raymond Reitsma
Well, the mix of classified versus not is pretty stable qualitatively within the more risky end of that spectrum. We have a number of exit credits that are working out as anticipated. The rehab credits in that group are healing is anticipated. So from where we sit, we don't expect surprises within that group.
Daniel Tomayo
Okay. And then just lastly on credit, the provision and net charge-offs, I mean, is there anything different that we should think about in terms of forecasting that loss provision number going forward or outside of the unusual number in the second quarter, do you still feel like that's relatively stable?
Charles Christmas
Yeah, Daniel, this is Chuck. I think we generally don't give guidance on provision. All the firms have their own different thoughts on the economy. And certainly, we can see especially as a commercial lender with some sizable credits.
Occasionally, we do have some one-offs, which hopefully will go the other way as we continue our collection efforts, namely on the two credits that I mentioned in my prepared remarks. So I would say if you look at a combination of the first and second quarter, kind of average them out is in general what our expectations would be as we sit here today.
Daniel Tomayo
Okay, terrific. Well, thanks for all the color, guys. I appreciate it. I'll step back.
Operator
Nathan Race, Piper Sandler.
Nathan Race
Yeah, hi, guys, good morning. Thanks for taking my questions. Just going back to Chuck's comments previously, in terms of the deposit and pricing environment being relatively stable of late. Just curious kind of how that trend in the margin unfolded over the course of second quarter. Was it relatively stable or kind of steady compression each month between April and June?
Charles Christmas
Yeah, I would say it was on a downward trend throughout the quarter. I think what we're seeing is that our deposits are repricing a little bit faster than what our assets are repricing as we kind of get to that equilibrium, say, as we've gone through the timing of events that I mentioned. But I think that we're getting we're getting close to the point here.
And you can see that in my guidance as we're getting close to a point of equilibrium, the CDs repricing today, while they're repricing, they're not repricing to the magnitude that they were certainly 12 months ago, even six months ago.
And then again, we continue to have the repricing on the asset side as well. So we think on an overall basis, it looks like the Fed's going to start lowering rates on a measured basis. We feel good about our balance sheet and that environment. So taking all that together, we think when we get here into the third and fourth quarter, is that our margin will be relatively stable at the levels that we projected.
Nathan Race
Got it, very helpful. And just speaking of repricing on the right side of the balance sheet. Chuck, can you remind us just in terms of what amount of non-maturity deposits can you reprice or kind of are commensurate with each cut?
Charles Christmas
Yeah, I think you kind of touched on something that it's going to be very interesting. I think, when we're all looking at trying to forecast our net interest margins as they come, the deposit betas are, of course, the biggest objective number that we put into our models, we put into our forecast. But I think now that we'll get -- they'll become very interesting if the Fed does, in fact, start lowering interest rates.
As we see how the competition reacts clearly, you've heard from our comments today, the loan-to-deposit ratio strategy is very important to us. So that's going to come into the mix as well. I think we've definitely seen some increases in time deposits. But the biggest level of increases by far are the money market rates.
Those are the ones that have been priced most aggressively, not just by us, but in the marketplace as well. So it's our expectation, it's I guess our hope that when the Fed does start lowering interest rates is that we'll see some meaningful declines in the rates being offered on that product within the marketplace as well.
Nathan Race
Okay, that's great. Very helpful. And then if I could just ask one more on kind of expenses and hiring efforts, just curious if the updated expense guide for the fourth quarter contemplates any hires that you guys are planning to maybe accelerate some progress on that deposit gathering front?
Charles Christmas
Yeah, our forecast definitely reflects our expectations in our workforce, whether we are hiring additional people or trying to fill existing spots right now. We're always looking for people on all facets of our company on the sales side, whether it be commercial lenders and/or primarily deposit gatherers.
I would say that we've done some very meaningful hires in the past 12 to 18 months on the deposit side. And we would definitely like to add to that and that some is somewhat budgeted and put into our forecast. But we are a growing company, we continue to expect to grow, and that will require increases in our workforce.
But one thing that we definitely have seen over the last couple of years is improvements in our inefficiencies, especially with our data analytics team. While we have grown as a company over the last couple of years, as you look at our FTEs, except for our summer intern program that we have that throws those numbers off a little bit from time, and again, you can see that our FTEs have been very stable.
And that it really is a reflection of us becoming more efficient internally. We're taking a look at all of our processes. We're getting smarter about what we're doing, but also the data analytics, the function has also had a nice impact on us helping our efficiency there as well.
Nathan Race
Okay. Great. I appreciate all the color. Thank you.
Operator
(Operator Instructions) Damon DelMonte, KBW.
Damon DelMonte
Hey, good morning, guys. Hope you're both doing well and thanks for taking my questions here. First one, just wanted to touch a little bit on loan growth. It sounds like the outlook remains pretty solid for you guys. Can you talk a little bit about what areas of your of your footprint are providing the best opportunities and kind of within those opportunities, what segments of the economy are providing good credit to you guys?
Raymond Reitsma
Hey, Damon, this is Ray. The loan opportunities have been pretty well-dispersed and not concentrated in any particular part of our geography. Of course, we have some concentration here in Grand Rapids because of the concentration of existing assets that we have here.
But in terms of new opportunities, they're spread around the state. And our searches, we grow our commercial book we're looking for good companies and good management teams. And what industry they're in is less important to us, we just absolutely want to find good management teams that will continue to uphold our credit quality. So we haven't focused in any particular areas of the economy. It's more company-specific driven.
Damon DelMonte
Got you. Okay. And then kind of switching to the loan yields, Chuck, I think they were kind of flat this quarter, quarter over quarter. Is that of a function of what you're seeing for new pricing opportunities in the market or is that more of a function of the majority of the portfolio has kind of been reset to current rates?
Charles Christmas
Yeah, I think it's a combination of both. Clearly we're up -- as at the end of the quarter, we're up to 70% of our commercial loans are floating rate. So clearly those going up seems to be done from market expectations and the Fed's next move.
We definitely have on an ongoing basis, we have fixed rate loans that were made in much lower rate environments coming up for maturity, and those are either leaving or paying off. But what happens most of the time is they're refinanced, they're bluing. So they're refinanced at existing rates. And I would say the yield in the current pricing marketplace is we're getting yields that are a little bit higher than our overall yields for sure. But the dollar amounts involved are not as significant.
Damon DelMonte
Got it. Okay. And I guess lastly, on capital, stocks had a very nice run lately. So I guess any updated thoughts on the buyback probably now at current levels?
Charles Christmas
We're obviously very pleased with the stock performance over the last week or so, and actually last month or so. I would say our thoughts on capital is that we want to preserve it as much as we can. Clearly, again, we're a growing company. You know, as everybody knows, there's different ratios that we and regulators look at when it comes to comparing that to capital levels. We want to make sure that we're in good stead there.
Clearly, we want to have some dry powder, whether it's taking advantage of opportunities. You never know about the economy, so we're pretty comfortable, kind of staying on the sidelines with the buyback program. Clearly, the prices are probably the biggest driver there. And so at these levels, certainly we would not expect to initiate any of that.
As you saw, we increased the dividend again as we typically do in the first and the third quarter, so increasing the cash return to our investors at a percent of earnings that we think makes sense for us, again, making sure that we have capital for the items that I spoke of.
Damon DelMonte
Yeah, got it. Okay, great. That's all that I had. Thank you very much.
Operator
This concludes our question-and-answer session. I would like to turn the conference back over to Ray Reitsma for any closing remarks.
Raymond Reitsma
Thank you for your participation in today's call and for your interest in Mercantile Bank. We appreciate it. And that concludes today's call.
Operator
The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.
