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 regulations; 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 center"), at September 30, 2009 to December 31, 2008 and the results of operations for the three and nine months ended September 30, 2009 and September 30, 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: ASC 740, Income Taxes, requires that companies assess whether a valuation allowance should be established against deferred tax assets based on the consideration of all available evidence using a "more likely than not" standard. Accordingly, we reviewed our deferred tax assets and determined that no valuation allowance was necessary at September 30, 2009.
In making decisions regarding any valuation allowance, we consider both positive and negative evidence and analyze changes in near-term market conditions, as well as other factors which may impact future operating results. Significant weight is given to evidence that can be objectively verified. Our significant negative evidence is our operating loss for 2008 and the first nine months of 2009, which puts us in a cumulative pre-tax loss position over the last three years, combined with a challenging economic environment and uncertainty in the timing of a meaningful economic recovery. Our positive evidence includes our: 1) history of strong earnings performance prior to 2008; 2) aggressive nature in identifying, administering and accounting for problem assets; 3) well capitalized regulatory capital position; 4) rapidly improving net interest margin; 5) substantial decline in wholesale funding reliance which in large part is due to a significant increase in local deposits; 6) decisions made that have lead to reduced salary, benefit, occupancy, furniture and equipments costs; and
7) cautiously optimistic expectations regarding future taxable income.

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MERCANTILE BANK CORPORATION Future realization of our deferred tax assets is highly dependent upon our forecasts of taxable income. While such forecasts cannot be guaranteed, we believe they have been developed in a conservative manner in regards to net interest margin expectations and the impact of potential further credit deterioration on provisions to our allowance. We expect our regulatory capital ratios to remain well above required minimums, thus ensuring our economic viability and ability to realize our deferred tax assets. The deferred tax assets will be analyzed quarterly for changes affecting realizability, and there can be no assurance that a valuation allowance will not be necessary in future periods.
Financial Overview
Our earnings performance has been negatively impacted by substantial provisions to the allowance. Ongoing state, regional and national economic struggles have negatively impacted some of our borrowers' cash flows and underlying collateral values, leading to increased nonperforming assets, higher loan charge-offs and increased overall credit risk within our loan portfolio. We continue to work with our borrowers to develop constructive dialogue to strengthen our relationships and enhance our ability to resolve complex issues; however, with the environment for the banking industry likely to remain stressed until economic conditions improve, credit quality will continue to be our major concern. We will remain vigilant in the identification and administration of problem assets, but provisions to the allowance will likely remain above historical levels, dampening future earnings performance.
Our earnings performance also reflects positive steps we have taken to not only partially mitigate the impact of deteriorating asset quality in the near term, but to benefit us on a longer term basis as well. First, our net interest margin has been expanding throughout 2009 as we replace maturing high-rate deposits with lower-cost funds, while at the same time our commercial loan pricing initiatives have offset the negative impact of an increase in nonaccrual loans. Despite a substantial reduction in total loans, our net interest income has increased due to the higher net interest margin, and we expect our net interest margin to improve further over the next few quarters. Next, our regulatory capital ratios have also increased, as the sale of preferred stock under the Treasury's Capital Purchase Program and the reduction of loans outstanding have more than offset the impact of recording a net loss. In addition, we have seen strong increases in local deposits, reflecting the successful implementation of various initiatives, campaigns and product enhancements. The local deposit growth, combined with the reduction of loans outstanding, has provided for a substantial reduction of, and reliance on, wholesale funds. Lastly, we are starting to see the positive effect of our branch consolidation and other overhead cost reduction initiatives, as we continue to make strides to reduce controllable noninterest expense.
Financial Condition
During the first nine months of 2009, our total assets decreased from $2,208.0 million on December 31, 2008, to $2,017.4 million on September 30, 2009. This represents a decrease in total assets of $190.6 million, or 8.6%. The decline in total assets was comprised primarily of a $242.7 million decrease in total loans and leases and a reduction of $4.3 million in securities, partially offset by a $40.9 million increase in cash and cash equivalents. The reduction in total assets provided for a $148.6 million decline in deposits and a decrease of $45.0 million in Federal Home Loan Bank advances, partially offset by an $8.4 million increase in securities sold under agreements to repurchase ("repurchase agreements").

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MERCANTILE BANK CORPORATION Commercial loans and leases decreased by $233.2 million during the first nine months of 2009, and at September 30, 2009 totaled $1,477.1 million, or 91.5% 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 $105.0 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 interest 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 73% 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 a significant 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, at September 30, 2009 and December 31, 2008:

September 30, 2009 December 31, 2008 Residential - Vacant Land $ 20,630,000 $ 21,374,000 Residential - Land Development 33,862,000 54,055,000 Residential - Construction 9,446,000 16,839,000 Commercial - Vacant Land 25,564,000 29,269,000 Commercial - Land Development 22,412,000 24,629,000 Commercial - Construction NonOwner Occupied 79,339,000 102,464,000 Commercial - Construction Owner Occupied 5,456,000 9,344,000 Commercial - NonOwner Occupied 528,727,000 558,360,000 Commercial - Owner Occupied 349,335,000 370,099,000 Total $ 1,074,771,000 $ 1,186,433,000

Residential mortgage loans and consumer loans decreased an aggregate $9.5 million during the first nine months of 2009. As of September 30, 2009, residential mortgage loans and consumer loans totaled a combined $137.2 million, or 8.5% 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 our 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. Market value estimates of collateral on impaired loans, as well as on foreclosed and repossessed assets, are reviewed periodically; however, we have a process in place to ensure value estimates at each quarter-end are reflective of current market conditions. Our credit policies establish criteria for obtaining appraisals and determining internal value estimates. We also adjust both outside and internal valuations based on identifiable trends within our markets, such as recent sales of similar properties or assets, listing prices and offers received.
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 net loan and lease charge-offs and nonperforming assets will remain elevated in comparison to our historical levels 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 nine months 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 September 30, 2009, nonperforming assets totaled $110.8 million, or 5.5% of total assets, an increase from the $57.4 million, or 2.6% of total assets, as of December 31, 2008, and from the $47.8 million, or 2.2% of total assets, as of September 30, 2008. As of September 30, 2009, nonperforming loans secured by CRE, combined with foreclosed properties, totaled $62.8 million. Nonperforming loans and foreclosed properties associated with the development of residential real estate totaled $26.7 million, with another $6.8 million in nonperforming loans secured by, and foreclosed properties consisting of, residential properties. Nonperforming C&I loans and repossessed assets totaled $14.5 million. Net loan and lease charge-offs during the first nine months of 2009 totaled $27.4 million, or an annualized 2.1% of average total loans and leases, compared to $13.5 million, or an annualized 1.0% of average total loans and leases, during the first nine months of 2008.
The following table provides a breakdown of nonperforming assets as of September 30, 2009 and net loan and lease charge-offs during the first nine months of 2009 by property type:

Nonperforming Foreclosed Net Loan & Lease Loans Assets Charge-Offs Residential - Land Development $ 9,056,000 $ 4,589,000 $ 2,151,000 Residential - Construction 11,942,000 1,079,000 4,317,000 Residential - Owner Occupied / Rental 5,988,000 842,000 2,701,000 Commercial - Land Development 3,700,000 921,000 74,000 Commercial - Construction 228,000 0 0 Commercial - Owner Occupied 20,265,000 1,164,000 1,922,000 Commercial - NonOwner Occupied 25,932,000 10,541,000 6,398,000 Commercial - NonReal Estate 14,131,000 379,000 9,625,000 Consumer - NonReal Estate 0 8,000 178,000 Total $ 91,242,000 $ 19,523,000 $ 27,366,000

Securities decreased $4.3 million during the first nine months of 2009, totaling $238.5 million as of September 30, 2009. Proceeds from called U.S. Government Agency bonds totaled $26.6 million during the first nine months of 2009, with another $13.2 million received from principal paydowns on mortgage-backed securities. In addition, $3.5 million was received from the matured and called tax-exempt municipal general obligation bonds. A majority of the proceeds were invested back into the securities portfolio, with $35.8 million invested in U.S. Government Agency bonds, $3.9 million invested in mortgage-backed securities and $1.0 million invested in tax-exempt municipal general obligation bonds. At September 30, 2009, the securities portfolio was comprised of U.S. Government Agency bonds (30%), U.S. Government Agency issued or guaranteed mortgage-backed securities (28%), tax-exempt municipal general obligations and revenue bonds (26%), Michigan Strategic Fund bonds (9%), Federal Home Loan Bank stock (7%) and mutual funds (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 fair value accounting requirements.
Cash and cash equivalents increased $40.9 million during the first nine months of 2009, totaling $66.7 million on September 30, 2009. The federal funds sold balance was up $41.5 million and short-term investments were up $1.7 million, while cash and due from bank balances were down $2.3 million. Given market conditions, we believe it is prudent to maintain relatively high balances of short-term liquid funds. During the first nine months of 2009, our average federal funds sold balance was about $57.0 million.
Premises and equipment at September 30, 2009 equaled $30.2 million, a decrease of $2.1 million over the past nine months. Purchases of premises and equipment during the first nine months of 2009 were nominal, while depreciation expense totaled $2.0 million.
Deposits decreased $148.6 million during the first nine months of 2009, totaling $1,451.0 million at September 30, 2009. Local deposits increased $185.7 million, while out-of-area deposits decreased $334.3 million. As a percent of total deposits, local deposits equaled 45.2% on September 30, 2009, an increase from 29.4% as of December 31, 2008. Noninterest-bearing demand deposits, comprising 7.5% of total deposits, decreased $2.2 million during the first nine months of . . .