Mercantile Bank Corp (MBWM) 2006 Q3 法說會逐字稿

Welcome to the Mercantile Bank Corporation's third quarter earnings conference call.

There will be a question-and-answer period at the end of the presentation. [OPERATOR INSTRUCTIONS]

Before we begin today's call, I would like to remind everyone 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 or its management, statements on economic performance and statements regarding the underlying assumption of the Company's business.

The Company's actual results could differ materially from any forward-looking statements made today due to several important factors described in the Company's latest Securities & Exchange Commission filings. The Company assumes no obligation to update any forward-looking statements made during this call.

If anyone does not already have a copy of the press release issued by Mercantile today, you can access it at the Company's Web site www.mercbank.com.

On the conference today from the Mercantile Bank Corporation we have Gerry Johnson, Chairman and Chief Executive Officer, Mike Price, President and Chief Operating Officer, Chuck Christmas, Senior Vice President and Chief Financial Officer, and Bob Kaminski, Executive Vice President. We will begin the call with the management's prepared remarks and then open the call up to questions.

At this point I would like the turn the call over to Mr. Johnson. Sir, you say begin.

Thank you very much and thank you all of you for dialing in this morning.

Although the first nine months of 2006 have been extremely challenging, I believe that the entire Mercantile Bank Corporation team has demonstrate its ability to produce superior results in a difficult operating environment.

Our challenges continue to come primarily in four areas. First, effecting a meaningful increase in current period earnings per share over the first nine months of 2005, notwithstanding the fact that the majority of our expansion costs into Lansing and Ann Arbor were not incurred until the second half of last year and our move into our new corporate headquarters did not begin to impact overhead expenses until May 2005. These timing differences do make comparing the first nine months of 2006 with the first nine months 2005 somewhat difficult to say the least.

Secondly, ongoing margin pressures brought about by highly competitive pricing of both loans and deposits, a flat yield curve and an industrywide trend [inaudible] intermediation of savings and money market deposits into higher costing CDs.

Third, growing our balance sheet in an environment that is increasingly competitive as we continue to gain market share at the expense of our competitors, who have shown an ongoing and aggressive willingness to compromise on deal structure, as well as undercut Mercantile's pricing on potential new as well as existing credit relationships oftentimes to absurdly low levels that are, in my opinion, unreflective of the proposed transactions credit risk.

And fourth, maintaining our historical and traditional asset quality numbers has also been a challenge but our metrics have remained consistent for three quarters and the slight increase in non-performers since December of 2005 continues, in our view, to be a short-term situation and not an indication of a secular trend.

I believe we have dealt very effectively with these challenges. First, diluted earnings per share increased 14.6% over the first nine months of 2005 and third quarter earnings per share reflected a 20.8% increase over the third quarter of 2005.

The 20.8% increase in third quarter '06 over third quarter '05 earnings is especially significant because our expansion costs are reflected in the results of both periods. Chuck will discuss this further in his remarks.

Secondly, our year-to-date margin at 3.44% is down 4 basis points from the prior year but third quarter '06 margin of 3.34% is 13 basis points lower than same period last year, which is a trend that Chuck will also discuss further.

Third, at September 30, 2006 total loans of $1.710 billion reflect an increase of $221 million, or 14.9% over loan balances on the same date last year and asset growth is $230 million, an increase of 12.8% over the prior year period.

During the quarter we surpassed $2 billion in assets. Helping us to fund this growth has been an excellent increase in local deposits and both Mike and Chuck will have further comments regarding our loan and deposit growth.

Fourth, with regard to non-performing assets and charge-offs, although our ratios remain well within peer group parameters, we continue to work diligently to bring these numbers back to historically low levels reflected in last year's performance. Mike will further expand on the developments in our loan portfolio.

I believe in summary, that we have dealt in our dealing very efficiently and effectively with the numerous challenges that we are facing in 2006.

I will now turn the conference call over to Chuck Christmas.

Thanks, Gerry, and good morning to everybody.

What I'd like to do this morning as typical is give you an overview of Mercantile's financial condition and operating results for the third quarter of 2006 and year-to-date 2006 highlighting the major financial condition and performance balances and ratios. As Gerry mentioned, our net income for the third quarter of this year was $5.2 million, an increase of $900,000, or about 21% over the $4.3 million that we earned in the third quarter of last year, and for the first nine months of 2006, we earned $15.2 million, an increase of $1.8 million, or about 14% over the $13.4 million we earned in the first nine months of last year.

On a diluted earnings per share basis third quarter of this year is $0.64, an increase of about 21% over the third quarter last year, and for the first nine months of 2005, we earned $1.88, an increase of almost 15% over what we earned in the first nine months of 2005. The increases in net income continue to be achieved due to growth in net interest income primarily resulting from earning asset growth, and up until last quarter, a relatively steady net interest margin, which more than offset increased provision expense and the initial costs associated with our expansion into the Lansing and Ann Arbor market in mid to late 2005.

Our overall profitability is driven by continued strong earning asset growth which is translated into increased net interest income. In the third quarter of this year net interest income totaled $15.5 million, an increase of $1.4 million, or 10% over the third quarter of last year, and for the first nine months of 2006 net interest income totaled $46.3 million, an increase of $6 million, or 15% over the first nine months of 2005.

Average earning assets during the third quarter of 2006 totaled $1.88 billion. That's an increase of $235 million, or about 14% over average earning assets in third quarter of 2005.

Average loans during the third quarter of 2006 totaled $1.68 billion. That's an increase of $244 million, or about 95% of the growth in average earning assets over the same period in 2005.

As Gerry mentioned, our net interest margin declined in the third quarter of 2006 at 3.34% compared to the second quarter at 3.47% and the third quarter of last year which was a similar 3.46%.

As fully expected, with the prime rate now holding steady resulting in a relatively flat yield on assets, but our continued cost of funds increases, fund increases in our fixed rate CD and Federal Home Loan Bank advance portfolios our net interest margin declined during the third quarter of 2006 after being relatively stable for many prior quarters.

With the market consensus expectation that the fed will hold the federal fund rates steady for the next three to six months, we expect further declines in our net interest margin during the next couple of quarters before leveling off.

While we continue to not provide specific guidance, as in the past the main issue impacted our net interest margin will be the wholesale funds portfolio. Our cost of wholesale funds have certainly increased and it will continue as maturing funds are replaced with funds at higher rates.

During the fourth quarter of 2006 we have approximately $225 million maturing at a weighted rate of 4.60%. In the first quarter of 2007 we have $245 million maturing at a rate of 4.7%, and in the second quarter of 2007 we have about $190 million maturing at a rate of 5.05%.

The twelve-month rate just for comparative purposes is currently about 5.25%, a rate that has declined quite dramatically over the last three months when at the end of the second quarter it was 5.60%.

Our loan loss provision expense in the third quarter totaled $1.35 million, an increase of $455,000, or 51% over the third quarter last year, and for the first nine months of 2006 totaled $4.1 million, an increase of $1.6 million, or 62% over the first nine months of 2005. We have a lower reserve coverage ratio and lower loan growth during these time periods, but that has been more than offset with higher level of net charge-offs.

Our non-interest income during the third quarter of this year totaled $1.4 million, up 2% from the third quarter of 2005, and for the first nine months of 2006 totaled $3.9 million, up 3% from the first nine months of 2005. We've had a small decline in service charges on deposit accounts primarily from the increased earnings credit rate, but that is being offset with modest increases in virtually all other fee income categories.

Our total non-interest expense for the third quarter of this year totaled $8 million, a decrease of $300,000 from what we expensed in the third quarter of 2005. During 2006 we have had no employee bonus accrual whereby in 2005 we did, but also in 2005, especially in the third and fourth quarter, we had significant signing and recruiter fees associated with our significant investment in addition to new hires to the bank.

On a year-to-date basis we expensed $24.1 million, an increase of $1.8 million, or about 8% over what we expensed in the first nine months of last year. We've had increased costs associated with significant increase in staffing facilities during mid to late 2005, and increased costs associated with troubled credit relationships during 2006 which have more than offset the fact that we have no employee bonus accrual in 2006 compared to 2005.

As of September 30th our total assets equaled $2.03 billion. For the quarter that's an increase of $45 million and during that same time our loans were up about $40 million.

In the last twelve months our assets have increased $244 million with loans comprising $221 million with a loan growth rate of about 15%. Again, we have no major changes in our asset structure or composition.

Our funding strategy has also not changed significantly. We continue to grow local deposits and bridge the funding gap with wholesale funds mainly brokered CDs and Federal Home Loan Bank advances.

We continue to experience very rapid deposit growth in our local markets, and during the first nine months of 2006 local deposits and funds are up $116 million, or almost 30% on annualized basis. Our wholesale funds are up only 6% during the same time period.

Average wholesale funds to total funds during the third quarter of 2006 equaled 65%, similar number from the second quarter of 2006 but down from the 69% in the third quarter of last year.

With regards to capital we remain in a [inaudible] cap position with a total risk based capital ratio of approximately 11.6% as of September 30, 2006.

That's my prepared remarks. Be happy to answer questions in the Q&A session. I'll now turn it over to Mike.

Thank you, Chuck. Good morning, everyone.

As Gerry and Chuck have already mentioned, we have just completed another very successful quarter here at Mercantile. I would like to briefly focus on three noteworthy areas for the third quarter.

Number one, expense control was outstanding, especially when considering that both salary and benefit expense and total non-interest expense were less than the third quarter of last year despite a 13% increase in assets and adding an additional 21 FTEs during the intervening twelve months.

Number two, growth continues to be very strong even with the Michigan economy in a difficult situation, and as Gerry said earlier, very thin pricing and structuring by our competitors.

Third, asset quality remains very solid as we continue to work through some difficult specific situations. Great progress was made during the later part of the third quarter which we expect to continue into the fourth quarter as well.

That's the end of my prepared remarks. As always, be glad to answer any questions at the end of the presentation, but I would like to turn it over at this point to Bob Kaminski.

Thank you, Mike.

In my comments at the end of the second quarter I mentioned that Mercantile had developed several initiatives to enhance deposit growth. As an update, Mercantile continues to see some very nice activity in health savings accounts including a significant relationship with one of the largest employers in this area. This area will continue to be a growing emphasis for the Mercantile Bank in the coming months.

Additionally, as Chuck highlighted, Mercantile continues to develop some good local deposit growth especially in some of our newer markets. Operationally, Mercantile is on track for a late fourth quarter '06 early first quarter '07 customer rollout of our next generation Internet banking product.

And finally, construction continues on our new Lansing banking facility and is on track for opening in late first quarter/early second quarter '07.

Those are my comments. I'll turn it back over to Gerry.

Thank you, Bob. At this point, we, in the conference, we would be happy to answer any questions.

[OPERATOR INSTRUCTIONS] Our first question is coming from Eric Grubelich of Keefe, Bruyette and Woods Incorporated. Please state your question.

Hi. Good morning

Good morning.

First question I have was for Mike Price.

Mike, the last comment you made was about asset quality. And did I understand you correctly that you said there was some great progress being made toward the end of the third quarter?

Correct.

Okay. So is the expectation that we should see some improvement in the NPA level?

Yeah, I would think so. There's a couple of significant NPAs that have been, especially real estate related that have been on, hanging on the balance sheet for the good portion of 2006, and we saw some good movement on disposition of some of those real estate assets, so I would expect a real good resolution to some of those in the fourth quarter as well as the first quarter of next year.

Okay. Great.

And then I think, Bob, you had just mentioned the information about the health savings accounts that you booked or signed a large relationship. Can you give me an idea of when you book business like that, is it going to show up in your deposit accounts? Is it going to show up as some extra fee income? What would I be looking for or am I not really going to notice this just looking at the numbers?

The health savings account is a fairly new product, obviously, and as I mentioned, we've been successful in landing a large relationship, and what you'll see with that is a significant number of new accounts, and those accounts are set up to start out with they won't have a tremendous amount of money, but they'll be subject to growth as the employees and the company contributes to them over the course of, a period of time.

In this case there happens to be a large number of accounts, so it will start to make an impact on the bank's overall deposit situation, and there will be some, obviously, some fee opportunities there with those accounts as well as some ancillary business that we hope to get by the relationship with the employer as well as the customers themselves.

Those deposits, what category are they in technically?

They are savings deposits.

Okay. Just in the savings category.

Right.

This is Mike. I want to amplify on what Bob was saying which is absolutely correct, but in addition, one of the exciting things about this is that it's a new relationship with a major medical provider here in town which is really one of our strategic initiatives for 2006 and beyond.

One of the things that's really taking off well here in Grand Rapids is the growth of the medical, I guess, business or community, and this was a real exciting opportunity for us to get our foot in the door with people we hadn't done so much with in the past and will give us an opportunity and entree into yet even further business in this particular area.

Okay. Great. And then one last question for Chuck.

So Chuck, you, thanks for providing the detail on the roll rates on the time deposits. Would it be correct to assume if the yield curve stays the same, there isn't a move either way by the Fed, that based on these numbers that you gave by the end of the second quarter you should be priced up to where market is?

That's a pretty fair statement on an overall basis. We'll still have a little bit of repricing upwards on the CDs after the first quarter, but it will be pretty modest, and you won't see that going through to any great degree with our margin going forward.

And just, Chuck, on that subject, what are your -- what's your posture right now? Have you been shortening up the duration of the time deposits or have you made any change there in the last quarter or two?

We've been shortening a little bit, but our averages right now probably about twelve months. As you know, we've been doing fifteen and eighteen months over the last couple years.

So we're shortening up a little bit, but certainly, as you know, there's really not a great degree of consensus out there with regards to what rates are actually going to do over the next twelve to eighteen months. Being cautious, obviously, the consensus is for rates to move lower, but there's certainly those out there that think that rates will stay level for a long time or perhaps even increase a little bit. So we're being pretty cautious on shortening the duration on that portfolio.

Okay. Thanks very much.

Thank you. Our next question is coming from Kevin Reevey of Ryan Beck & Company Incorporated. Please state your question.

Good morning, guys. How are you?

Good. How are you?

Good, thanks.

Can you talk about the loan growth? It looks like this quarter the average loans were up about 2.5% which is slower than it was in the prior quarter and then slower than it's been historically.

Is that due to competition? Was that a conscious effort to slow loan growth given wacky pricing out there by competitors? I just wanted to get some more color on that.

Sure, Kevin, this is Mike. I'd be glad to try to address that for you.

As always, we always have a very aggressive growth posture here at the Bank, but we want to make sure it makes sense from a rate standpoint, and Gerry touched on this a little bit earlier, that it's commensurate with the risks that you have to take. Clearly, we don't sneak up on anybody any more so some of the larger players have done some things that we found just totally unacceptable on either pricing and/or structure of the loan.

In addition, during the quarter we did some pruning of the portfolio as we normally do, but especially in the third quarter there were just some larger credit situations that we asked to exit the Bank because the risk profile had change to a point where we were not comfortable with them, and those were the two major reasons why growth in addition, obviously, the Michigan economy isn't helping us out a lot right now, so those are the real reasons why the growth was a little bit less than what we normally do, but compared to most banks that are operating in the markets that we're operating in, we're very, very happy that we continue to show a pretty good growth rate.

And then the 13 basis point linked quarter margin compression, was that more on the funding side or was that mainly due to the lack of repricing upward on the loan side?

Kevin, [inaudible] it's pretty much a combination of both. Over the last 18 to 24 months we've had repricings on both of those but with a high level of loans tied to prime, our assets were repricing quicker. Now that the prime did not really increase during the third quarter to speak of so our asset yield pretty much leveled off. It was up a little bit, but certainly our cost of funds were up much higher.

Primarily when you look at the numbers themselves, primarily the result of increases in our funding costs with relatively small increase in our asset yield.

And then a final question. Watch list trends, how are they looking?

Watch list trends, Kevin, have been very good the last couple of months, and that's why my comments earlier of the good progress during the third quarter. As you know, the watch list is that precursor as to where your NPAs and charge-offs eventually end up and we had a nice reduction in the number of credits and the volume of credits dollar volume on the watch list the last couple of months.

Great. Thank you.

You bet.

Thank you. Our next question is coming from Terry McEvoy from Oppenheimer & Company. Please state your question.

Thanks. Good morning.

Good morning.

Wonder if you can provide a progress report or an update on the Ann Arbor and Lansing initiatives? Essentially are they on track with some of the goals you laid out in mid-to late year, and if so, is it based on some of the competitive pressure that has been mentioned throughout this call?

Sure, Terry, this is Mike, and I'll start with that and if any of the other gentlemen want to add to it, that'd be great.

The Lansing market, we'll handle that one first, has done extremely well on the loan growth, especially in the last couple of quarters, and we look at what they have in the backlog list, and that looks really, really strong, and the story in Ann Arbor has been just kind of the opposite. There's been some really strong local deposit growth in the Ann Arbor branch for us, so that's been exciting.

If I were to say, compared to what we expected, and we have some high expectations of everything we do around here, I'd like to see Lansing do a little bit better on the deposit side and Ann Arbor do a little bit better on the loan side, but both the gentlemen that run those markets will probably tell you I'll never be happy with them no matter what they do. But they've done a good job, and the teams there have been very, very strong, and overall we're happy with what's going on.

The competition in Holland and Lansing and Ann Arbor is fierce just like it is here in Grand Rapids, and I wouldn't expect that to be, probably, I think everybody at least in the Midwest would say that what's going on in the banking world these days, but overall pretty darn happy with what they're doing.

Thanks.

And then on the competitive pressure and expense levels, are there any initiatives internally to keep expenses down? I know they were down in the quarter and any growth initiatives may have been put on hold in terms of -- in anticipation of things kind of improving or is it just business as usual and you'll work through it?

It's a little bit -- there's no growth initiatives that have been put on hold. I think it's just one of those situations where we look at some of our competitors, they're acting with a little bit of an air of desperation.

I think we've taken a lot of market share away from some players who have been used to being kind of complacent in the market, and it's woke them up a little bit, and we had one major competitor the other day priced a loan at 6.5% fixed for five years and then turned around and offered another customer on a very large CD over 6% fixed for three years, and I don't have my abacus handy, but even I know that that's not a very good long-term plan.

Our focus is to continue doing what we do very well which is to build relationships. We don't like when the other banks are doing things that we find irrational, but I think we believe in the rationality of the market, and sooner or later they're not going to be able to continue to do that and survive.

As far as expense initiatives, at 47% efficiency ratio, there's not a lot of expense initiatives going on here at the Bank because our people are pretty darn efficient, and we want to make sure that we continue to have a level of customer service that we need and that we're known for, so that's kind of where we're at. We continue to work hard. We continue to build those relationships and weather the storm.

One quick last question.

Was there any trend or consistency between the loans relationships that you were essentially asking to leave the bank in the third quarter?

In consistency in trending in what way as far as what businesses they may be involved in or markets?

Right. Yes.

A couple of them that we worked down significantly in the third quarter were automotive related. I would say those are probably the biggest trend or consistency that I would bring out to you.

They were Grand Rapids credits, and other than that, there isn't really any one significant thing that ties them together except for the two largest were automotive related.

Thanks, Mike, appreciate it.

You bet.

Thank you. Our next question is coming from Brad Vander Ploeg from Raymond James. Please state your question.

If I could just follow-up maybe to Kevin's question about loan growth. Can you comment maybe on the sort of the general economic health of the markets that you're operating in and what you see as the opportunity for organic growth?

You talked a little bit about competition and, obviously, the external environment's not helping a lot, but just wondering where the growth is coming from? Is it largely new relationships, is it higher utilization rates, is it you stealing clients away from others or just new business opportunities and economic growth?

I would say, this is Mike again, the majority of our growth continues to be relationships that move to us after being very dissatisfied with the levels of service that they are getting from our competitors, however, in the last couple of quarters we are starting to see some of our existing customer base expand a little bit. It's slow going, but we've seen some optimism with some of our customers, and we've been able to get some loan growth out of that.

That's pretty much the story across the board in all of the markets that we're in. We kind of do it the way we've done it since the day we opened the doors and it's just by good old-fashioned making the calls, establishing the relationships.

Most of the people that we have on board as far as the senior group have long tenures in the markets that they're in. They know a lot of people, and if we don't get the business right away, we typically just keep working at it, working on it until we're able to steal it away.

But you're right in your comment that this isn't North Carolina or one of those states where you get a lot of help from just normal expansion. However, we are seeing some growth here in Grand Rapids, especially in the medical business and related entities there.

Brad, this is Gerry.

I think you know us well enough to know that we've never grown this Company just for the sake of growing it, and we've had good growth because of our reputation, because of our service levels, and the rates of growth are going to vary from the time to time based just on the comments that Mike made.

One of the things that we don't do is say we have to grow this Bank $300 million this year, and we're going to do it any way we can. We just, as I said, you know us well enough to know that's not how we've operated.

Absolutely.

On your comment about the competition, I mean you're not the only ones in the Midwest saying that there's some irrational competition going on out there. One would think that that would normalize at some point. What do you think that takes, a credit shock or have the pricing dynamics changed permanently?

Yeah, I think, again, this is Mike.

I think what happens, what we see it as one of the big competitors, I can only guess, but somebody in the headquarters and in a few states away says what in the heck is happening in that market in Michigan. You need to go out there and bring the business back in, and it's kind of like Gerry said, you do it at all costs and all structure, and so we typically will see a bank kind of have an initiative about six months or nine months of well, if Mercantile's involved, you've got the free ticket to do whatever you want to do from a pricing and structure standpoint, and then it usually goes away because the same person sitting in that other market starts looking at the returns or the credit losses going, now what are you doing, and then someone else jumps in that picture for a while, but I think as we see the economy in Michigan pick up, which I got to believe it is going to, you can't be, I don't think 50th in economic growth for forever, at least I hope not.

I think some of that will normalize as well as when the results start to hit the bottom line. That certainly will help it normalize.

And one final sort of unrelated thing.

In terms of the bonus accruals, I always get a little bit worried when I see a company that has grown rapidly as yours has when you start doing something like that. Do you worry at all about losing people or is this largely the people who are on this call right now who I wouldn't expect would be going anywhere?

Well I think we do a lot of work with talking to our employees and, certainly, people on this call right now feel the sting of no bonus more than anybody, but it reaches everybody in the Company. And so we are always cognizant of that, Brad, and we do a good job of communicating, or at least we think we do, communicating with our employees and letting them know where we stand, what we can do to try to achieve those goals, how it looks, how it's going to look for the next year, and we also work very closely with our Board to pick out targets for the next year and the year beyond as to what are appropriate targets for bonuses.

But we hear you, we're with you on that, and it is always a concern, but I don't really look at it because we feel -- I know we're parochial when we say this, but we feel it's a pretty darn good place to work and we take pretty good care of the employees. Gerry, if you want to add.

Brad, if you look at our salary, our benefits, the other things that we do for our employees, it probably is much greater than our competition, and this is the first year I think since we started that we have not been accruing a non-lender bonus.

If we did this every other year, I think it would send a different message but everybody knows this has been a tough year, some situations a little bit out of our control, but we are very hopeful that we will be accruing and paying bonuses again in 2007. I think most people are willing to accept that and go along with us.

All right. Excellent. Thanks very much.

Thanks, Brad.

Thank you. Our next question is coming from Ben Crabtree of Stifel Nicolaus. Please state your question.

Thank you. I guess I'd like to follow-on onto that question about the bonus accrual.

If for some reason, let's say, who knows what it would be, but all of a sudden the margin would be way better in the fourth quarter than you expected and you'd have a very strong quarter, I guess I'm trying to figure out how the mechanics of this work. Would you, if it looked like for the year you were going to be up 15%, would you hit the fourth quarter for the full-year bonus accrual?

Ben, this is Chuck.

And how it works is it's an annual program and for this year in 2006 as it was last year, I believe, or at least this year was a 15% growth in net income year-over-year. How we budget that is to basically take one twelfth of what we expect to expense for the whole year assuming a full payout, but then what we do at the end of each quarter is we evaluate what we've done on a year-to-date basis and compare that to what we did on a year-to-date basis the prior year, but we also do some internal forecasting and try to determine what it's going to look like when we get to the end of the current year.

So we try to level it off as best we can based on actual results year-to date as well as our forecast.

So --

Ben, this is Gerry.

I would also add that that 15% has to include the bonus accrual. That's not we're up 15%, let's pay ourselves some bonuses.

Okay. I was going to ask you that. Okay.

That's not, we're up 15% let's pay ourselves some bonuses.

Right. Which would mean all of a sudden you weren't up 15 anymore.

Exactly. The 15% has got to be after any bonuses are paid.

Just a question.

I mean given, you know, let's say the volatility in that line, wouldn't it make sense to have various steps instead of such an abrupt change? I mean just from the standpoint of modeling it, but that's a fairly big number.

Well, when you say steps, the 15%, if earnings were up 16% we would have a percent to play with. But that wouldn't equate to a full bonus payout for anybody.

But if it's, they were up 12, for example, there would be zero payout?

That's correct.

Okay. All right. Okay. Well, I guess that's pretty much the whole subject then.

I mean if one adds that accrual back in then, obviously, expenses were not down year-over-year. I mean the bonus accrual in the third quarter of last year must have been, I mean, I'm guessing 400 or $500,000?

Yeah, Ben, this is Chuck. It's a little over half million.

Okay.

So if it's an apples-to-apples, then the operating expense would have been up a couple percent instead of down 3.5 or something.

Yeah, but one thing you also got to remember is we have all the costs associated [inaudible] with our expansions, our main headquarters and other things in there as well.

I'm not being critical, I was just going to make sure that we were clear on the thing.

If I could ask one other question, and this relates to the funding on the deposits. What was the amount of the deposits, the maturity in the third quarter, and what was the rate on them so I can maybe figure out what the impact was on spread income from that.

I don't have that specific number with me. I'm going to give some estimates, but please realize that they are estimates and it was probably about $250 million, probably in the 445 range. But that is an estimate.

And chances are if you replaced it in like maturity, the negative gap on that was bigger than what we would see right to now given what's happened on cost of funds?

Definitely. When we were at this point three months ago, everybody thought the Fed was going to raise again in August. Obviously the money market rates took that into account, and we had a pretty significant increase in market rates in gyp and July and towards the end of July and certainly into August after they med and didn't raise rates, we saw a large decline in over all market rates.

I fact, just to put it in perspective, our trust preferred securities repriced in the middle of July and then will again in the middle of October. If the LIBOR's, three-month LIBOR stays where it is today, next week, let's see a 20-point decline in the cost of that for the next quarter.

And that's how big of abrupt a change we saw in the third quarter, but certainly, what we paid for CDs and Federal Home Bank advances in the third quarter will very likely be quite a bit higher than what we'll pay in the fourth quarter and beyond given the current rate environment and expectations.

And should we assume that those would kind of matured steadily through the quarter and weren't frond end loaded or back loaded?

That's correct. Pretty consistent.

Okay.

So I guess the bottom line of this is the negative, the marginal change was probably worse in the third quarter than, assuming no change in rate, the marginal hit was bigger in the third quarter than it will be going forward?

I think the third and fourth will be fairly similar, though. Because you've got, what you did in August and September, obviously, is not fully factored in the third quarter and part of that will bleed into the fourth quarter.

Got you. Thank you.

Thank you. Our next question is coming from Howell Ridley of Security Financial Advisors. Please state your question.

Good morning, gentlemen, great quarter. Have three or four questions for you.

Of the $45 million net loan growth for the quarter, how much of that would you say is attributable to Ann Arbor and Lansing?

We figured that it's about 40%.

That's quite significant.

Yes, it is, that's like that we're very happy with what both of them are contributing.

Okay.

And how does your pipeline look at this time versus, say, three months ago and more or less, same as or what?

I think compared to three months ago, the pipeline looks, I would say about the same, but I feel better about the number of credits we're going to ask to go away. If I can put that delicately and it's about as delicate as I put it.

But I think a lot of the pruning that we knew we had to do three months ago and that we started even six months ago has been done, not to say there isn't more, and there is, but that number, I think, is a lot less. So I'd say I'm feeling better about net growth this quarter than I was three months ago, and I think that's what you're really looking for.

Net loan growth of $45 million, what would you estimate that you disassociated yourself with, how much in loans?

I'm going to guess about 12 to $14 million.

So gross was close to $60 million.

That would be a good number to look at and, you know, we're not going to go to zero in pruning credits, but I think it will be less than it was this last quarter.

Is there any way or does the Bank presently have any correspondent banks or any relationships outside of this area or outside the state of Michigan where they can get loan growth from other parts of the country?

No. We've tried to avoid that generally because we like the asset quality that we get from organic growth and maybe we're just control freaks, but we like to be the main participant or the main driver of what happens with loan structuring. So it's really insignificant, the one or two small credits that we do participate in.

And also you can keep an eye on something that's closer to home.

Oh, yeah.

Last question. Any plans for brick and mortar in Ann Arbor?

At this point the only brick and mortar, as you probably know, Howell, that we have going on is in Lansing, and that, and I think Bob mentioned it will be opening in the early part of next year, but Ann Arbor or, the team there is evaluating what they want to do with brick and mortar, but the facility that we have there now is leased, and we're pretty happy with it, and so there are no current plans to do anything in Ann Arbor.

You always don't have to have brick and mortar to make money.

Well, we've proven that. We try to use it very judiciously.

Well keep up the great job, and you met your words, as you said things would improve when you start having year-over-year comparisons on an equal basis. Keep up the good work.

Thanks, Howell.

Yes.

Gentlemen, we have a follow-up question from Eric Grubelich of Keefe, Bruyette and Woods. Please state your question.

Mike, I just wanted to clarify a comment about the pruning of the credit. Do you think in the fourth quarter the credits you want to push out the door, the impact will be a little bit less than it was in the third quarter? Is that what I --?

Yes. Yes.

Okay. Good.

And then maybe for you or Gerry, now that the Fed is at least, again, if we're just going to assume that rates stay the same, prime's not going to change, how concerned are you when you look at the yield on a loan portfolio that because of competition you might actually see yields come down as opposed to maybe some loans in the portfolio that are up for a three-year repricing?

What's the relationship there? Do you think the yield stays firm or do you see pressure on the yield now that the Fed stopped because of competition?

This is Mike. I'll start and if Gerry wants to add on, certainly he can amplify my comments.

There clearly is pressure on loan yields at this point, and your question is a very good one, and we really work very hard on a really week-to-week basis to look at deals that we're competing on right now and when we get repricing chances when loans mature, if they get out and get shopped, there is a lot of competition there, and quite honestly, some deals we've had to let go because it just doesn't meet our pricing matrix of where we want to be, and that's painful because we're a growth company, and our team takes a lot of pride in getting and keeping relationships or bringing in new ones. So the answer to your question specifically, I think there's a tremendous amount of pressure on that.

Do I think the yield is going to decline because of it? I'd say probably not because we're pretty disciplined on that end of it, and as Gerry said before, we're not growing just for growth sake, so if we see something that's priced too cheaply, we generally let it go unless, and this is a big unless, there's some other part of the relationship, whether it be deposit or fee income or something down the road where we can look at it and say the whole picture makes sense for us to take maybe a little less pricing on the front end.

Eric, this is Chuck. Let me just add a little bit more to what Mike said as well.

Most of our balloons are coming up are five-year balloons which means we're looking at the end of '01 and, obviously, into 2002 in a relatively very low rate environment. So when you look at the loans that are scheduled to balloon, say, in 2007, they're coming off some pretty low rate environments. So notwithstanding the competition, the fact that they are relatively low rate will help mediate some of that concern with our competition.

That's what I was -- I probably could have asked the question a little bit more clearly, but I was trying to get a handle on that, and I think the point that Mike raised that, yeah, if you see some stupid pricing you're going to let the loan go, I understand that, too, you may lose some volume, but that's not necessarily going to whack your loan yield.

Right.

There's multiple parts of the equation. I understand that. Okay. Thanks very much.

Thank you.

Thank you. Our next question is coming from Steven [Glenn] of Stifel Nicholas. Please state your question.

Yes, you might have answered this question earlier, or provided a similar, but could you give the percent of loans that are fixed?

Our percent of loans that are fixed, and I'm going to include those loans that are currently under ceilings is about 50% by half our loans are fixed and half are floating. Now if you factor, if you take off the caps that have been reached, it's probably about 65, 66% of our loans that are truly floating but, again, a portion of those have hit ceilings.

And last question, the automotive industry has experienced some pressure. Could you talk about the stress this is putting on some of the other industries in your market?

And on the reverse side you had mentioned some industries, or at least some companies are performing a little bit better with maybe some uptick in loan demand. Maybe, could you kind of generalize and say some industries are performing a little better?

This is Mike again.

To answer the first part of your question, I mean anybody in the automotive food chain, if you will, suppliers, even 1-2-3 off, especially the domestic big three, there's just stress and strain all up and down that whole supply thing, and that Mercantile and Michigan aren't the only ones feeling that, that's for sure, and it really came on two fairly large credits that we had that we were able to get resolved during the quarter that really came to bear. We don't have any other really large automotive to that size. We had these two particular ones in our portfolio, so that's good.

As far as other industries, I mentioned a little bit. We're seeing a lot of, in Grand Rapids specifically, some growth in anything to do with the medical industry, and that's been good, and there's just been a lot of other various smaller companies that are in just pretty diverse industries that have just clicked along very, very well during these difficult times, and I wouldn't say there's any one industry there that no matter what market in that we're finding that does especially well that I could lump them all into, but right now anything automotive is definitely feeling the stress.

Okay. Thank you.

You bet.

Thank you. Our next question is coming from John Rowen of Sidoti & Company. Please state your question.

Good morning, everyone.

Good morning, John.

Most of my questions were already asked. Chuck, could you just go over again the CD maturings over the next few quarters?

Sure, John.

In the fourth quarter of this year it's about $225 million at a rate of 4.60. In the first quarter of next year it's about $245 million at 4.70 and in the second quarter of next year it's $190 million at 5.05.

Great. Thank you.

Gentlemen, there are no further questions at this time.

That will conclude our teleconference. Thank you all again for your interest in Mercantile, and with that we will conclude. Thank you.

Ladies and gentlemen, this does conclude today's teleconference. Thank you for your participation, and you may disconnect your lines at this time.