Summary of MERCANTILE BANK CORP

Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Forward Looking Statements
This report contains forward-looking statements that are based on management's beliefs, assumptions, current expectations, estimates and projections about the financial services industry, the economy, and our company. Words such as "anticipates," "believes," "estimates," "expects," "forecasts," "intends," "is likely," "plans," "projects," and variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions ("Future Factors") that are difficult to predict with regard to timing, extent, likelihood and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed or forecasted in such forward-looking statements. We undertake no obligation to update, amend, or clarify forward-looking statements, whether as a result of new information, future events (whether anticipated or unanticipated), or otherwise. Future Factors include, among others, changes in interest rates and interest rate relationships; demand for products and services; the degree of competition by traditional and non-traditional competitors; changes in banking regulation; changes in tax laws; changes in prices, levies, and assessments; the impact of technological advances; governmental and regulatory policy changes; the outcomes of contingencies; trends in customer behavior as well as their ability to repay loans; changes in local real estate values; changes in the national and local economies; and risk factors described in our annual report on Form 10-K for the year ended December 31, 2008 or in this report. These are representative of the Future Factors that could cause a difference between an ultimate actual outcome and a forward-looking statement.
Introduction
The following discussion compares the financial condition of Mercantile Bank Corporation and its consolidated subsidiaries, Mercantile Bank of Michigan ("our bank"), our bank's three subsidiaries, Mercantile Bank Mortgage Company, LLC ("our mortgage company"), Mercantile Bank Real Estate Co., LLC ("our real estate company") and Mercantile Insurance Center, Inc. ("our insurance company"), at March 31, 2009 to December 31, 2008 and the results of operations for the three months ended March 31, 2009 and March 31, 2008. This discussion should be read in conjunction with the interim consolidated financial statements and footnotes included in this report. Unless the text clearly suggests otherwise, references in this report to "us," "we," "our" or "the company" include Mercantile Bank Corporation and its consolidated subsidiaries referred to above. Critical Accounting Policies
Accounting principles generally accepted in the United States of America are complex and require us to apply significant judgment to various accounting, reporting and disclosure matters. We must use assumptions and estimates to apply these principles where actual measurements are not possible or practical. Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our unaudited financial statements included in this report. For a complete discussion of our significant accounting policies, see footnotes to our Consolidated Financial Statements included on pages F-39 through F-44 in our Form 10-K for the fiscal year ended December 31, 2008 (Commission file number 000-26719). Our allowance for loan and lease losses policy and accounting for income taxes are highly dependent upon subjective or complex judgments, assumptions and estimates. Changes in such estimates may have a significant impact on the financial statements, and actual results may differ from those estimates. We have reviewed the application of these policies with the Audit Committee of our Board of Directors.

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MERCANTILE BANK CORPORATION Allowance for Loan and Lease Losses: The allowance for loan and lease losses ("allowance") is maintained at a level we believe is adequate to absorb probable incurred losses identified and inherent in the loan and lease portfolio. Our evaluation of the adequacy of the allowance is an estimate based on past loan and lease loss experience, the nature and volume of the loan and lease portfolio, information about specific borrower situations and estimated collateral values and assessments of the impact of current and anticipated economic conditions on the loan and lease portfolio. Allocations of the allowance may be made for specific loans or leases, but the entire allowance is available for any loan or lease that, in our judgment, should be charged-off. Loan and lease losses are charged against the allowance when we believe the uncollectibility of a loan or lease balance is likely. The balance of the allowance represents our best estimate, but significant downturns in circumstances relating to loan and lease quality or economic conditions could result in a requirement for an increased allowance in the future. Likewise, an upturn in loan and lease quality or improved economic conditions may result in a decline in the required allowance in the future. In either instance, unanticipated changes could have a significant impact on operating earnings. The allowance is increased through a provision charged to operating expense. Uncollectible loans and leases are charged-off through the allowance. Recoveries of loans and leases previously charged-off are added to the allowance. A loan or lease is considered impaired when it is probable that contractual interest and principal payments will not be collected either for the amounts or by the dates as scheduled in the loan or lease agreement. Impairment is evaluated in aggregate for smaller-balance loans of similar nature such as residential mortgage, consumer and credit card loans, and on an individual loan basis for other loans. If a loan or lease is impaired, a portion of the allowance is allocated so that the loan or lease is reported, net, at the present value of estimated future cash flows using the loan's or lease's existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Loans and leases are evaluated for impairment when payments are delayed, typically 30 days or more, or when serious deficiencies are identified within the credit relationship. Our policy for recognizing income on impaired loans is to accrue interest unless a loan or lease is placed on nonaccrual status. We put loans or leases into nonaccrual status when the full collection of principal and interest is not expected.
Income Tax Accounting: Income tax liabilities or assets are established for the amount of taxes payable or refundable for the current year. Deferred income tax liabilities and assets are also established for the future tax consequences of events that have been recognized in our financial statements or tax returns. A deferred income tax liability or asset is recognized for the estimated future tax effects attributable to temporary differences that can be carried forward
(used) in future years. The valuation of current and deferred income tax liabilities and assets is considered critical as it requires us to make estimates based on provisions of the enacted laws. The assessment of tax liabilities and assets involves the use of estimates, assumptions, interpretations and judgments concerning accounting pronouncements, federal and state tax codes and the extent of future taxable income. There can be no assurance that future events, such as court decisions, positions of federal and state tax authorities, and the extent of future taxable income will not differ from our current assessments, the impact of which could be significant to the consolidated results of operations and reported earnings. We believe our tax liabilities and assets are adequate and are properly recorded in the consolidated financial statements. Financial Condition
During the first three months of 2009, our assets increased from $2,208.0 million on December 31, 2008, to $2,239.8 million on March 31, 2009. This represents an increase in total assets of $31.8 million, or 1.4%. The growth in total assets was comprised primarily of a $111.5 million increase in cash and cash equivalents, more than offsetting a $78.9 million reduction in total loans and leases. Total deposits increased $51.7 million, while Federal Home Loan Bank ("FHLB") advances decreased $10.0 million.

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MERCANTILE BANK CORPORATION Commercial loans and leases decreased by $77.6 million during the first three months of 2009, and at March 31, 2009 totaled $1,632.7 million, or 91.8% of the total loan and lease portfolio. This decline reflects the slowdown in business activity in our markets and the impact of a concerted effort on our part to reduce exposure to certain non-owner occupied commercial real estate ("CRE") and automotive-related businesses. The biggest decline occurred in the commercial and industrial ("C&I") loan portfolio, where usage of commercial lines of credit was reduced by about $40.0 million, in large part reflecting the slowdown in business activity and a corresponding reduction in accounts receivable and inventory financings. We would expect to see an increase in commercial line of credit usage when economic conditions improve. Our systematic approach to reducing our exposure to certain CRE lending will be pro-longed, given the nature of CRE lending and the current depressed economic conditions; however, we believe that such a reduction is in our best interests when taking into account the increased inherent credit risk, relatively low loan rates and nominal deposit balances associated with targeted borrowing relationships.
The commercial loan and lease portfolio represents loans to businesses generally located within our market areas. Approximately 70% of the commercial loan and lease portfolio is primarily secured by real estate properties, with the remaining generally secured by other business assets such as accounts receivable, inventory and equipment. The continued significant concentration of the loan and lease portfolio in commercial loans and leases is consistent with our stated strategy of focusing a substantial amount of our efforts on "wholesale" banking. Corporate and business lending is an area of expertise for our senior management team, and our commercial lenders have extensive commercial lending experience, with most having at least ten years' experience. Of each of the loan categories that we originate, commercial loans and leases are most efficiently originated and managed, thus limiting overhead costs by necessitating the attention of fewer employees. Our commercial lending business generates the largest portion of local deposits, and is our primary source of demand deposits.
The following table summarizes our loans secured by real estate, excluding residential mortgage loans representing permanent financing of owner occupied dwellings and home equity lines of credit, as of March 31, 2009:

          Residential - Vacant Land                     $    22,244,000
          Residential - Land Development                     50,402,000
          Residential - Construction                         14,646,000
          Commercial - Vacant Land                           28,775,000
          Commercial - Land Development                      24,636,000
          Commercial - Construction NonOwner Occupied        93,322,000
          Commercial - Construction Owner Occupied            9,290,000
          Commercial - NonOwner Occupied                    556,280,000
          Commercial - Owner Occupied                       365,250,000


          Total                                         $ 1,164,845,000

Residential mortgage loans and consumer loans decreased an aggregate $1.3 million during the first three months of 2009. As of March 31, 2009, residential mortgage and consumer loans totaled a combined $145.4 million, or 8.2% of the total loan and lease portfolio. Although residential mortgage loan and consumer loan portfolios may increase in future periods, we expect the commercial sector of the lending efforts and resultant assets to remain the dominant loan portfolio category given our wholesale banking strategy.

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MERCANTILE BANK CORPORATION Our credit policies establish guidelines to manage credit risk and asset quality. These guidelines include loan review and early identification of problem loans and leases to provide appropriate loan and lease portfolio administration. The credit policies and procedures are meant to minimize the risk and uncertainties inherent in lending. In following these policies and procedures, we must rely on estimates, appraisals and evaluations of loans and leases and the possibility that changes in these could occur quickly because of changing economic conditions. Identified problem loans and leases, which exhibit characteristics (financial or otherwise) that could cause the loans and leases to become nonperforming or require restructuring in the future, are included on the internal "watch list". Senior management reviews this list regularly. The levels of net loan and lease charge-offs and nonperforming assets have increased since early 2007. Although we were never directly involved in the underwriting of or the investing in subprime residential real estate loans, the apparent substantial and rapid collapse of this line of business during 2007 throughout the United States had a significant negative impact on the residential real estate development lending portion of our business. The resulting decline in real estate prices and slowdown in sales has stretched the cash flow of our local developers and eroded the value of our underlying collateral, which caused elevated levels of nonperforming assets and net loan and lease charge-offs. Since that time, we have witnessed rapidly deteriorating economic conditions in Michigan and throughout the country. The resulting decline in business revenue has negatively impacted the cash flows of many of our borrowers, some to the point where loan payments have become past due or will likely become delinquent in future periods. In addition, real estate prices have fallen significantly, thereby exposing us to larger-than-typical losses in those instances where the sale of collateral is the primary source of repayment. It is likely that the levels of net loan and lease charge-offs and nonperforming assets will remain elevated until economic conditions improve.
As of December 31, 2007, nonperforming assets totaled $35.7 million, or 1.68% of total assets, an increase from the $9.6 million, or 0.46% of total assets, as of December 31, 2006. As of December 31, 2007, nonperforming loans secured by real estate, combined with foreclosed properties, totaled $28.6 million, or about 80% of total nonperforming assets. Nonperforming loans and foreclosed properties associated with the development of residential real estate totaled $11.1 million, with another $3.2 million in nonperforming loans secured by, and foreclosed properties consisting of, residential properties. Net loan and lease charge-offs during 2007 totaled $6.7 million, or 0.38% of average total loans and leases. Net loan and lease charge-offs during the fourth quarter of 2007 totaled $3.9 million, or about 58%, of the total net loan and lease charge-offs for all of 2007. During 2006, net loan and lease charge-offs totaled $4.9 million, or 0.29% of average total loans and leases.
Throughout most of 2008, we experienced deterioration in a number of commercial loan relationships which previously had been performing fairly well. Analysis of certain commercial borrowers revealed a reduced capability on the part of these borrowers to make required payments as indicated by factors such as delinquent loan payments, diminished cash flow, deteriorating financial performance, or past due property taxes, and in the case of commercial and residential development projects slow absorption or sales trends. In addition, commercial real estate serves as the primary collateral source for many of these borrowing relationships and updated evaluations and appraisals in many cases reflected significant declines from the original estimated values.

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MERCANTILE BANK CORPORATION During the fourth quarter of 2008 and the first quarter of 2009, we saw a continuation of the stresses caused by the weakening and poor economic conditions, especially in the CRE markets and automotive-related borrowing relationships in our C&I portfolio. High vacancy rates or slow absorption has resulted in inadequate cash flow generated from some real estate projects we have financed, and has required guarantors to provide personal funds to make full contractual loan payments and pay other operating costs. In some cases, the guarantors' cash and other liquid reserves have become seriously diminished. In other cases, sale of the collateral, either by the borrower or us, is our primary source of repayment.
As of March 31, 2009, nonperforming assets totaled $83.7 million, or 3.74% of total assets, an increase from the $57.4 million, or 2.60% of total assets, as of December 31, 2008, and from the $40.6 million, or 1.92% of total assets, as of March 31, 2008. As of March 31, 2009, nonperforming loans secured by CRE, combined with foreclosed properties, totaled $37.1 million. Nonperforming loans and foreclosed properties associated with the development of residential real estate totaled $26.2 million, with another $4.9 million in nonperforming loans secured by, and foreclosed properties consisting of, residential properties. Net loan and lease charge-offs during the first quarter of 2009 totaled $5.6 million, or an annualized 1.25% of average total loans and leases. The following table provides a breakdown of nonperforming assets as of March 31, 2009 and net loan and lease charge-offs during the first quarter of 2009 by property type:

                                                         Nonperforming         Foreclosed          Net Loan & Lease
                                                             Loans               Assets              Charge-Offs

Residential - Land Development                          $    10,630,000        $ 2,016,000        $          624,000
Residential - Construction                                   13,440,000             98,000                    86,000
Residential - Owner Occupied / Rental                         3,216,000          1,661,000                 1,442,000
Commercial - Land Development                                 1,312,000          1,071,000                         0
Commercial - Construction                                             0                  0                         0
Commercial - Owner Occupied                                   7,754,000            999,000                    75,000
Commercial - NonOwner Occupied                               25,237,000          3,127,000                   786,000
Commercial - NonReal Estate                                  12,749,000            406,000                 2,475,000
Consumer - NonReal Estate                                        31,000                  0                   136,000


Total                                                   $    74,369,000        $ 9,378,000        $        5,624,000

Securities decreased by $0.2 million during the first three months of 2009, totaling $242.6 million as of March 31, 2009. Proceeds from called U.S. Government Agency bonds totaled $10.7 million during the first three months of 2009, with another $3.4 million received from principal paydowns on mortgage-backed securities. A vast majority of the proceeds were invested back into the securities portfolio, with $10.0 million invested in U.S. Government Agency bonds and $2.6 million invested in mortgage-backed securities. At March 31, 2009, the portfolio was comprised of U.S. Government Agency bonds (26%), U.S. Government Agency issued or guaranteed mortgage-backed securities (32%), tax-exempt municipal general obligations and revenue bonds (27%), Michigan Strategic Fund bonds (9%), Federal Home Loan Bank stock (6%) and a mutual fund (less than 1%).

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MERCANTILE BANK CORPORATION Market values on our U.S. Government Agency bonds, mortgage-backed securities issued or guaranteed by U.S. Government Agencies and tax-exempt municipal securities are determined on a monthly basis with the assistance of a third party vendor. Evaluated pricing models that vary by type of security and incorporate available market data are utilized. Standard inputs include issuer and type of security, benchmark yields, reported trades, broker/dealer quotes and issuer spreads. The market value of other securities is estimated at carrying value as those financial instruments are generally bought and sold at par value. We believe our valuation methodology provides for a reasonable estimation of market value, and that it is consistent with the requirements of SFAS No. 157.
Cash and cash equivalents increased $111.5 million during the first three months of 2009, totaling $137.3 million on March 31, 2009. Cash and due from bank balances were up $0.4 million, short term investments increased $29.9 million and federal funds sold were up $81.2 million. During the latter part of the first quarter, we experienced a significant influx of cash resulting from a reduction in total loans and leases (about $79.0 million) and growth in local retail and municipal certificates of deposit (about $130.0 million). Although we immediately started to reduce the level of wholesale funds, the inflow of cash far outpaced the outflows from wholesale funding maturities. For yield and risk diversification purposes, we invested part of the excess funds into short term certificates of deposit with a correspondent bank, with an aggregate balance of $30.0 million at March 31, 2009. During the initial stages of the second quarter, we continued to utilize our relatively significant short term investment and federal funds positions to fund wholesale funding maturities, with our cash and cash equivalents returning to a more normalized level in early May.
Premises and equipment at March 31, 2009 equaled $31.7 million, a decrease of $0.6 million over the past three months. Purchases of premises and equipment during the first three months of 2009 were nominal, while depreciation expense totaled $0.6 million.
Deposits increased $51.7 million during the first three months of 2009, totaling $1,651.3 million at March 31, 2009. Local deposits increased $133.9 million, while out-of-area deposits decreased $82.2 million. As a percent of total deposits, local deposits equaled 36.6% on March 31, 2009, an increase from 28.5% as of December 31, 2008. Noninterest-bearing demand deposits, comprising 6.8% of total deposits, increased $1.9 million during the first three months of 2009. Savings deposits (3.2% of total deposits) increased $2.6 million, interest-bearing checking accounts (3.1% of total deposits) increased $1.5 million and money market deposit accounts (1.4% of total deposits) decreased $1.8 million during the first three months of 2009. Local certificates of deposit, comprising 22.1% of total deposits, increased $129.7 million during the first three months of 2009. The growth primarily reflects an influx of new depositors resulting from a one year certificate of deposit campaign we ran during part of the first quarter and from municipal depositors.
Out-of-area deposits decreased $82.2 million during the first three months of 2009, totaling $1,047.0 million at March 31, 2009. Out-of-area deposits consist primarily of certificates of deposit obtained from depositors located outside our market areas and placed by deposit brokers for a fee, but also include certificates of deposit obtained from the deposit owners directly. The owners of out-of-area deposits include individuals, businesses and municipal governmental units located throughout the United States. The decline in out-of-area deposits during the first three months of 2009 primarily reflects the influx of cash resulting from the reduction in total loans and leases and from the increase in local deposits. Additional reductions in out-of-area deposits are expected during the second quarter as we use a large portion of the significant level of short term investments and federal funds sold at March 31, 2009 to fund wholesale funding maturities.

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MERCANTILE BANK CORPORATION Repurchase agreements decreased by $2.4 million during the first three months of 2009, totaling $92.0 million as of March 31, 2009. As part of our sweep account program, collected funds from certain business noninterest-bearing checking accounts are invested into over-night interest-bearing repurchase agreements. Such repurchase agreements are not deposit accounts and are not afforded federal deposit insurance.
FHLB advances decreased $10.0 million during the first three months of 2009, totaling $260.0 million as of March 31, 2009. The FHLB advances are collateralized by residential mortgage loans, first mortgage liens on multi-family residential property loans, first mortgage liens on commercial real estate property loans, and substantially all other assets of our bank, under a blanket lien arrangement. Our borrowing line of credit as of March 31, 2009 totaled about $314.0 million, with availability approximating $44.0 million. FHLB advances, along with out-of-area deposits, are the primary components of our wholesale funding program.
Liquidity
Liquidity is measured by our ability to raise funds through deposits, borrowed funds, capital or cash flow from the repayment of loans and securities. These funds are used to fund loans, meet deposit withdrawals, maintain reserve requirements and operate our company. Liquidity is primarily achieved through the growth of local and out-of-area deposits, advances from the FHLB and federal funds purchased, as well as liquid assets such as securities available for sale, matured and called securities, and federal funds sold. Asset and liability management is the process of managing our balance sheet to achieve a mix of earning assets and liabilities that maximizes profitability, while providing adequate liquidity.
In general, our liquidity strategy is to fund earning asset growth with deposits, repurchase agreements and FHLB advances and to maintain an adequate level of short- and medium-term investments to meet typical daily loan and deposit activity. Although deposit and repurchase agreement growth from customers located in our market areas has historically generally increased, this growth has not been sufficient to meet our historical substantial loan growth and provide monies for additional investing activities. To assist in providing the additional needed funds, we have regularly obtained monies from wholesale funding sources. Wholesale funds, comprised primarily of certificates of deposit from customers outside our market areas and advances from the FHLB, totaled $1,322.0 million, or 65.5% of combined deposits and borrowed funds as of March 31, 2009, compared to $1,414.2 million, or 71.5% of combined deposits and borrowed funds as of December 31, 2008.
Although local deposits have historically generally increased as new business, . . .