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MBWM > SEC Filings for MBWM > Form 10-Q on 8-Nov-2012All Recent SEC Filings

Show all filings for MERCANTILE BANK CORP



Quarterly Report

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 or actions by bank regulators; 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, 2011 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.


The following discussion compares the financial condition of Mercantile Bank Corporation and its consolidated subsidiaries, Mercantile Bank of Michigan ("our bank"), and 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 September 30, 2012 and December 31, 2011 and the results of operations for the three and nine months ended September 30, 2012 and September 30, 2011. 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 discussion of our significant accounting policies, see Note 1 of the Notes to our Consolidated Financial Statements included on pages F-47 through F-54 in our Form 10-K for the fiscal year ended December 31, 2011 (Commission file number 000-26719). Our allowance for loan 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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Allowance for Loan Losses: The allowance for loan losses ("allowance") is maintained at a level we believe is adequate to absorb probable incurred losses identified and inherent in the loan portfolio. Our evaluation of the adequacy of the allowance is an estimate based on past loan loss experience, the nature and volume of the loan portfolio, information about specific borrower situations and estimated collateral values, guidance from bank regulatory agencies, and assessments of the impact of current and anticipated economic conditions on the loan portfolio. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in our judgment, should be charged-off. Loan losses are charged against the allowance when we believe the uncollectability of a loan is likely. The balance of the allowance represents our best estimate, but significant downturns in circumstances relating to loan quality or economic conditions could result in a requirement for an increased allowance in the future. Likewise, an upturn in loan 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. Uncollectable loans are charged-off through the allowance. Recoveries of loans previously charged-off are added to the allowance. A loan 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 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 is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan's existing rate or at the fair value of collateral if repayment is expected solely from the collateral. The timing of obtaining outside appraisals varies, generally depending on the nature and complexity of the property being evaluated, general breadth of activity within the marketplace and the age of the most recent appraisal. For collateral dependent impaired loans, in most cases we obtain and use the "as is" value as indicated in the appraisal report, adjusting for any expected selling costs. In certain circumstances, we may internally update outside appraisals based on recent information impacting a particular or similar property, or due to identifiable trends (e.g., recent sales of similar properties) within our markets. The expected future cash flows exclude potential cash flows from certain guarantors. To the extent these guarantors provide repayments, a recovery would be recorded upon receipt. Loans 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 is placed on nonaccrual status. We put loans into nonaccrual status when the full collection of principal and interest is not expected.

Income Tax Accounting: Current income tax liabilities or assets are established for the amount of taxes payable or refundable for the current year. In the preparation of income tax returns, tax positions are taken based on interpretation of federal and state income tax laws for which the outcome may be uncertain. We periodically review and evaluate the status of our tax positions and make adjustments as necessary. 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 our net deferred income tax asset is considered critical as it requires us to make estimates based on provisions of the enacted tax laws. The assessment of the realizability of the net deferred income tax asset 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 assessment, the impact of which could be significant to the consolidated results of operations and reported earnings.


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Accounting guidance requires that we assess whether a valuation allowance should be established against our deferred tax assets based on the consideration of all available evidence using a "more likely than not" standard. In making such judgments, 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. During 2011, we returned to pre-tax profitability for four consecutive quarters. Additionally, we experienced lower provision expense, continued declines in nonperforming assets and problem asset administration costs, a higher net interest margin, a further strengthening of our regulatory capital ratios and additional reductions in wholesale funding. This positive evidence allowed us to conclude that, as of December 31, 2011, it was more likely than not that we returned to sustainable profitability in amounts sufficient to allow for realization of our deferred tax assets in future years. Consequently, we reversed the valuation allowance that we had previously determined necessary to carry against our entire net deferred tax asset starting on December 31, 2009.

Financial Overview

Over the past several years, our earnings performance was negatively impacted by substantial provisions to the allowance as well as administrative costs associated with problem assets. Ongoing state, regional and national economic struggles negatively impacted some of our borrowers' cash flows and underlying collateral values, leading to an elevated level of nonperforming assets, higher loan charge-offs and increased overall credit risk within our loan portfolio. We have worked with our borrowers to develop constructive dialogue to strengthen our relationships and enhance our ability to resolve complex issues. Although we have experienced significant improvement in our asset quality since the beginning of the latter part of 2010, in part due to modestly improving economic conditions, the environment for the banking industry will likely remain stressed until economic conditions further improve.

We recorded a net profit for the third quarter of 2012, our seventh consecutive quarterly net profit after over two years of quarterly losses. A significantly lower provision expense has primarily provided for the improved earnings performance; however, our improved earnings performance also reflects the many initiatives over the past several years to not only partially mitigate the impact of asset quality-related costs in the near term, but to benefit us on a longer-term basis as well. First, our net interest margin has improved as we have lowered local deposit rates and have replaced maturing higher-rate deposits and borrowed funds with lower-cost funds, while at the same time our commercial loan pricing initiatives have helped to mitigate the negative impact of a relatively high level of nonaccrual loans and more recently competitive commercial loan pricing pressures. In addition, we are increasing our local deposit balances, reflecting the successful implementation of various initiatives, campaigns and product enhancements. The local deposit growth, combined with the reduction of loans outstanding, have provided for a substantial reduction of, and reliance on, wholesale funds. Next, our regulatory capital position has increased substantially, primarily reflecting the impact of the net income recorded during the past seven quarters. Lastly, improved asset quality has provided for reductions in problem asset administration costs, while our improved financial condition and operating performance have resulted in lower Federal Deposit Insurance Corporation ("FDIC") insurance assessments.

Our improved financial condition and earnings performance were major contributing factors to our decision to repurchase the $21.0 million in non-voting preferred stock issued in May 2009 to the U.S. Department of the Treasury under the Treasury's Capital Purchase Program, as part of the Troubled Asset Relief Program, during the second quarter of 2012. In addition, during the third quarter of 2012, we repurchased the warrant we had issued to the U.S. Department of the Treasury on May 15, 2009 in connection with our participation in the Capital Purchase Program, for $7.5 million. The warrant provided the U.S. Department of the Treasury with the right to purchase 616,438 shares of our common stock at a price of $5.11 per share.


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Our asset quality metrics remain on an improving trend, and we are optimistic that the positive trend will continue. In aggregate dollar amounts, nonperforming asset levels have declined almost 70% since the peak level at March 31, 2010, and at September 30, 2012, were at the lowest level since December 31, 2007. Progress in the stabilization of economic and real estate market conditions has provided for numerous loan rating upgrades, significantly lower volumes of loan rating downgrades and reduced net loan charge-offs, allowing for substantially lower provision expense. We expect a continuation of improved market conditions will provide for lower future period provision expense and problem asset administration costs when compared to levels over the past several years.

Financial Condition

During the first nine months of 2012, our total assets decreased $44.9 million, and totaled $1.39 billion as of September 30, 2012. The decline in total assets was comprised primarily of a $37.3 million decrease in securities and a $37.1 million reduction in total loans, more than offsetting a $27.6 million increase in cash and cash equivalents. Our total liabilities declined $24.4 million during the first nine months of 2012. Securities sold under agreements to repurchase ("repurchase agreements") decreased $12.5 million, Federal Home Loan Bank ("FHLB") advances declined $10.0 million and total deposits decreased $4.5 million. In addition, shareholders' equity declined $20.4 million primarily due to the $21.0 million repurchase of preferred stock and the $7.5 million repurchase of the common stock warrant, more than offsetting the $8.5 million in net income attributable to common shares.

Our loan portfolio is primarily comprised of commercial loans. Commercial loans declined $39.5 million during the first nine months of 2012, and at September 30, 2012 totaled $957.4 million, or 92.5% of the loan portfolio. The decline in outstanding balances primarily reflects the impact of a concerted effort on our part to reduce the level of nonperforming commercial loans and commercial loans on our watch list (i.e., loans internally graded 7 and 8 - see Note 3 for additional information on our internal commercial loan grading system), as well as exposure to certain non-owner occupied commercial real estate ("CRE") lending. We did extend credit to several new commercial loan relationships and saw increased activity from some of our existing commercial loan customers during the first nine months of 2012; however, due in part to the ongoing sluggishness in business activity in our markets, our efforts to reduce the exposure to certain market segments and competitive pressures, our commercial loan portfolio declined. Loans collateralized by owner-occupied CRE increased $4.3 million and commercial and industrial ("C&I") loans increased $11.2 million during the first nine months of 2012. Line of credit usage was relatively unchanged during the period, although we would expect to see an increase in commercial line of credit usage when economic conditions improve. During the same nine month time period, loans collateralized by non-owner occupied CRE decreased $34.8 million and loans collateralized by multi-family and residential rental properties declined by $14.9 million. Our systematic approach to reducing our exposure to certain non-owner occupied CRE lending will be prolonged, given the nature of CRE lending and depressed economic conditions; however, we believe that such a reduction is in our best interest when taking into account the increased inherent credit risk and nominal deposit balances generally associated with the targeted borrowing relationships.

The commercial loan portfolio represents loans to businesses generally located within our market areas. Approximately 72% of the commercial loan 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 concentration of the loan portfolio in commercial loans is consistent with our strategy of focusing a substantial amount of our efforts on commercial 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 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.


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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:

                                       9/30/12           6/30/12           3/31/12          12/31/11           9/30/11
Vacant Land                         $   6,042,000     $   5,435,000     $   5,591,000     $   5,679,000     $   5,673,000
Land Development                       14,639,000        15,256,000        16,173,000        17,007,000        17,441,000
Construction                            4,031,000         4,055,000         4,318,000         4,923,000         4,647,000

                                       24,712,000        24,746,000        26,082,000        27,609,000        27,761,000
Comm'l Non-Owner Occupied:
Vacant Land                             8,793,000         8,827,000         9,255,000        10,555,000        11,082,000
Land Development                       13,798,000        14,355,000        14,418,000        14,486,000        14,541,000
Construction                            9,877,000        15,424,000        16,936,000        13,615,000        11,061,000
Commercial Buildings                  333,407,000       350,762,000       357,128,000       376,805,000       397,279,000

                                      365,875,000       389,368,000       397,737,000       415,461,000       433,963,000
Comm'l Owner Occupied:
Construction                            5,316,000         3,751,000         6,198,000         4,213,000         2,986,000
Other                                   6,617,000         6,811,000         7,246,000         7,445,000         7,591,000
Commercial Buildings                  271,364,000       281,519,000       273,376,000       268,479,000       269,776,000

                                      283,297,000       292,081,000       286,820,000       280,137,000       280,353,000

Total                               $ 673,884,000     $ 706,195,000     $ 710,639,000     $ 723,207,000     $ 742,077,000

Residential mortgage loans and consumer loans increased in aggregate $2.4 million during the first nine months of 2012, and at September 30, 2012, totaled $77.9 million, or 7.5% of the total loan portfolio. Although the 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.

Our credit policies establish guidelines to manage credit risk and asset quality. These guidelines include loan review and early identification of problem loans to provide appropriate loan 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 the possibility that changes in these could occur quickly because of changing economic conditions. Identified problem loans, which exhibit characteristics (financial or otherwise) that could cause the loans to become nonperforming or require restructuring in the future, are included on the internal watch list. Senior management and the Board of Directors review 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 monitor whether 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 may also adjust 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. In addition, we may discount certain appraised and internal value estimates to address distressed market conditions.


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The levels of net loan charge-offs and nonperforming assets have been elevated since early 2007. The substantial and rapid collapse of the residential real estate market that began in 2007 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 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 charge-offs. Since 2007, we have also witnessed stressed economic conditions in Michigan and throughout the country. The resulting decline in business revenue negatively impacted the cash flows of many of our borrowers, some to the point where loan payments became past due. 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. Also during this time, we have seen deterioration in guarantors' financial capacities to fund deficient cash flows and reduce or eliminate collateral deficiencies.

Throughout 2008, we experienced a rapid deterioration in a number of commercial loan relationships which previously had been performing satisfactorily. 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 is the primary source of collateral for many of these borrowing relationships and updated evaluations and appraisals in many cases reflected significant declines from the original estimated values.

Throughout 2009, 2010, 2011 and the first nine months of 2012, we saw a continuation of the stresses caused by the poor economic conditions, especially in the CRE markets. High vacancy rates or slow absorption have resulted in inadequate cash flow generated from some real estate projects we have financed, and have 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.

We are, however, encouraged by the apparent credit quality stabilization within our loan portfolio that began during the latter part of 2010. After a period of significant and ongoing increases from 2007 through September 30, 2009, the level of nonperforming assets was relatively unchanged through June 30, 2010 and then has generally declined through the end of the 2012 third quarter. Of particular note are the reduced level of additions to the nonperforming asset category and increased level of interest in, and sales of, foreclosed properties and assets securing nonperforming loans.

As of September 30, 2012, nonperforming assets totaled $35.9 million, or 2.6% of total assets, compared to $60.4 million (4.2% of total assets) and $56.8 million (3.8% of total assets) as of December 31, 2011 and September 30, 2011, respectively. The $24.5 million reduction during the first nine months of 2012 and the $20.9 million decline during the twelve-month period ended September 30, 2012, are associated with assets in all major categories as reflected in the table below. As of September 30, 2012, nonperforming loans and foreclosed properties associated with residential real estate totaled $9.4 million, reflecting reductions of $4.6 million and $7.9 million during the past nine and twelve months, respectively. Nonperforming loans secured by, and foreclosed properties consisting of, non-owner occupied CRE properties totaled $17.6 million at September 30, 2012, reflecting reductions of $12.5 million and $4.8 million during the past nine and twelve months, respectively.


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The following table provides a breakdown of nonperforming assets by property type:

                                   9/30/12          6/30/12          3/31/12          12/31/11         9/30/11
Residential Real Estate:
Land Development                 $  3,318,000     $  3,946,000     $  3,762,000     $  5,479,000     $  8,139,000
Construction                          645,000          965,000        1,242,000        1,397,000        1,418,000
Owner Occupied / Rental             5,426,000        5,982,000        6,437,000        7,138,000        7,737,000

                                    9,389,000       10,893,000       11,441,000       14,014,000       17,294,000
Commercial Real Estate:
Land Development                    1,158,000        1,174,000        1,531,000        2,111,000        1,885,000
. . .
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