Mercantile Bank Corp (MBWM) 2006 Q4 法說會逐字稿

Welcome to the Mercantile Bank Corporation fourth quarter and full year earnings conference call. [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 assumptions of the Company's business. The Company's actual results could differ materially from any forward-looking statements made today due to the several important factors described in the Company's latest Securities and 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 website at www.mercbank.com. On the conference today from Mercantile Bank Corporation we have Jerry 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 management's prepared remarks and then open the call up to questions. At this point I would like to turn the call over to Mr. Johnson. Sir, you may begin.

Thank you. Thank all of you for dialing in this morning. Although 2006 was an extremely challenging year, the management and staff of Mercantile Bank Corporation have continued to demonstrate their ability to produce superior results in a difficult operating environment. Our challenges this year were primarily in three areas. First, ongoing margin pressures brought about by highly competitive pricing of both loans and deposits exacerbated by the flat yield curve and an industry wide trend and the December mediation of savings and money market deposits into higher costing CDs. Secondly, 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 unreflective of the proposed transaction's credit risk. And third, maintaining our historical and traditional asset quality numbers. However, our metrics have remained consistent with regard to asset quality for the entire year, and the slight increase in non-performers since year end 2005 continues in our view to be a short-term situation and not an indication of a longer-term trend.

I believe we have dealt very effectively with these challenges during 2006. For the year diluted earnings per share increased 11.4%. Total loans increased 183.7 million or 11.8%, and asset growth is 229.1 million, an increase of 12.5%. During the year we surpassed 2 billion in assets. Helping us to fund this growth has been an excellent increase in local deposits. Mike and Chuck will have further comments regarding our loan and deposit growth.

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 the historically low levels reflected in our prior year's performance. Mike will further expand on the developments in our loan portfolio. Our new markets had a significant positive impact on our ability to continue to grow our earnings and assets at double-digit rates. Mike will have additional comments on Holland, Lansing, and Ann Arbor. I believe in summary that we have dealt very efficiently and effectively with the numerous challenges tha we faced in 2006 and have produced excellent results for our shareholders. I will now turn the conference call over to Chuck.

Thanks, Jerry. Good morning, everybody. What I would like to do this morning is give you an overview of Mercantile's financial condition and operating results for the fourth quarter of 2006 and all of 2006 highlighting the major financial condition and performance balances and ratios. Our net income for the fourth quarter of 2006 was $4.6 million, an increase of 0.1 million or 1% over the 4.5 million recorded in the fourth quarter of 2005. For all of 2006 our net income came in at $19.8 million. That's an increase of 1.9 million or about 11% over the 17.9 million recorded in 2005.

On a diluted earnings per share basis our fourth quarter 2006 was $0.57 compared to $0.56 in the fourth quarter of 2005, an increase of about 2% and for all of 2006 our diluted earnings per share was $2.45, an increase of about 11% over the $2.20 earned in 2005. Our increases in net income continue to be achieved due to growth in net interest income resulting from earning asset growth which more than offset our lower net interest margin and increased provision expense.

Our overall profitability is driven by continued strong earning asset growth which is translated into increased net interest income. In the fourth quarter of 2006 our net interest income totaled $15.3 million, an increase of $300,000 or 2% over 2005's fourth quarter and for all of 2006 our net interest income totaled 61.6 million. That's an increase of 6.3 million or about 11% over 2005. Our average earning assets for the fourth quarter of 2006 came in at $1.94 billion. That's an increase of 229 million or 13% over average earning assets during the fourth quarter of 2005. Our average loans in the fourth quarter of 2006 average $1.73 billion, an increase of $210 million or about 92% of the average earning asset growth from the fourth quarter of 2005.

As fully expected, with the prime rate now holding steady resulting in a relatively flat yield on assets by our continued cost of fund increases in our fixed rate CD and Federal Home Loan Bank advance portfolios our net interest margin continued to decline during the fourth quarter of 2006 after being relatively stable for many prior quarters up until the third quarter of 2006. Our net interest margin for the fourth quarter was 3.19% compared to the 3.34% in the third quarter of 2006 and 3.47% in the second quarter of 2006. With the market consensus expectation that the federal hold the federal funds rate steady for the next three to six months, we expect a further decline in our net interest margin during the next couple of quarters before leveling off.

As in the past, the main issue impacting our net interest margin will be the repricing of the wholesale funds portfolio, but also continued extreme competitive pressures on loan and deposit rates and the flat to inverted yield curve. The cost -- our cost of wholesale funds have increased and will continue for the next couple of quarters as maturing funds are replaced with funds at higher rates although not to the degree as in the recent past quarters. For the first quarter of 2007 wholesale funds maturing totaled $260 million with a average rate of 4.80%. In the second quarter of 2007 our wholesale funds maturing totaled $220 million with an average rate of 5.10%, and for the last six months of 2007 wholesale fund maturities totaled $335 million with an average rate of 5.25%. Currently the twelve month CD rate to put things in perspective for you equals about 5.25%.

Our loan loss provision expense in the fourth quarter of 2006 totaled $1.7 million. That's an increase of 400,000 or 34% over the fourth quarter of '05, and for all of 2006 our loan loss provision expense totaled $5.8 million. That's an increase of $2 million or 52% over the 2005 expense. A lower reserve coverage ratio and lower loan growth more than offset -- gross more than offset with higher level of net loan charge-offs.

Our fee income from the fourth quarter of 2006 totaled $1.4 million, down 27% from the fourth quarter of 2005 and for all of 2006 totaled 5.3 million, down 7% from 2005, but if we exclude the $700,000 -- or excuse me, the $0.7 million one time gain on the sale of tax credits in the fourth quarter of 2005, fee income during the fourth quarter of 2006 was up 15% and for all of 2006 was up 6%. Our overhead costs for the fourth quarter of 2006 totaled $8.2 million. That's a decrease of 0.6 million or 7% from what was expensed in the fourth quarter of 2005, and for all of 2006 totaled $32.3 million. That's an increase of $1.2 million or 4% from all of 2005. Increased costs associated with significant increase in staff and facilities during mid to late 2005 and increased costs associated with troubled debt -- troubled credit relationships during 2006 more than offset no employee bonus accrual in 2006.

As of December 31, 2006, our assets totaled $2.07 billion. That's an increase of $40 million during the fourth quarter of 2006 with loans being up $35 million. During the last twelve months assets increased $229 million or about 12% with loans up 184 million are also up about 12%. There continues to be no major changes in our asset composition. Our funding strategy also has not changed significantly as we continue to grow local deposits as best we can and bridge any funding gap with wholesale funds, namely brokered CDs and Federal Home Loan Bank advances. Our local deposit and repo growth during 2006 was very, very strong, up $190 million or 36%. Our wholesale funds were up as well, but only up $51 million or about 5%. Our average wholesale funds to total funds at the end of 2006 totaled 61% compared to 65% as of September 30, 2006, and 68% at the beginning of 2006. The Company continues to be in a well-capitalized position per bank regulatory definitions with a total risk-based capital ratio at year end '06 of 11.5%. With that I will turn it over to Mike for his remarks.

Thank you, Chuck, and good morning, everyone. Mercantile Bank of Michigan completed another strong year, especially considering the market dynamics facing commercial banks in general nationally which are especially challenging in Michigan. As Chuck and Jerry have already mentioned asset growth was 13%, slightly less than the traditional growth rate of past years for Mercantile, but well ahead of the 9% growth rate reported by the FDIC for all banks through nine months of 2006. The difficult economic times and competitive pressures have made asset growth more difficult, but the Mercantile team of bankers continues to develop strong numbers of new relationships across all of our markets.

Non-performing assets held relatively steady during the year at 0.46% of total assets. While this is higher than historical levels at Mercantile, it compares favorably with what is happening both nationally and within our Michigan peer group. FDIC statistics for all insured banks at 9/30/06 indicate a non-performing ratio of 0.49% of total assets. Additionally at 9/30/06 a peer group of 40 publicly traded Michigan banks reveals a nonperforming asset rate of 0.66%.

Our newer markets continue to be strong complements to our Kent County franchise contributing 50% of our net new loan growth for the year and 41% of our net new local deposit growth. Both Holland and Lansing are profitable operations with Washtenaw rapidly nearing break even. While certain current metrics of 2007 portend a challenging year for all banks, we're excited about the continued success of our sales efforts. Mercantile has become one of the premier banks in each market we compete in. This ends my prepared remarks. I certainly will be glad to answer any specific questions you have during the Q&A, but at this time I would like to turn it over to Bob Kaminski.

Thank you, Mike. I have just a couple of operational updates this morning. Construction remains on track at our new Lansing facility. We are currently anticipating opening of this building in the month of May. Mercantile continues to prepare for first quarter customer rollout of our next generation Internet banking product. This product will give some features and functionality that will allow us to continue to grow this avenue of banking for Mercantile customers. Finally, 2006 was a big year for health savings account penetration at Mercantile Bank. Toward the end of the year primarily through partnership with one of the area's largest employers we opened over 700 agency accounts bringing in $0.5 million in new account relationship dollars. I will now turn it back over to Gerry.

Thank you, Bob. With that we will now take questions.

[OPERATOR INSTRUCTIONS] Our first question is from Terry McEvoy with Oppenheimer. Please proceed with your question.

Good morning.

Good morning, Terry.

A couple questions. First off, this is the first quarter that I have seen at Mercantile where the provision did not match and exceed charge-offs. Was that due just to the the loan growth maybe being a little lighter in the fourth quarter than what we've seen historically or was there something else that occurred to drive that event?

Terry, this is Bob. We go through a calculation each month, each quarter, that arrives at what the provisions should be for the bank for the period, and through the dynamics of the portfolio and changes in loan grades and such that's the way the calculation worked out for the quarter, and it happened so that it did not match the charge-offs, but there were some other shifts in the portfolio that made it acceptable provision.

Okay. Then you mention quite a bit in the press release and on the call about the competitive landscape. Have you seen, comparing fourth quarter to third quarter, did it -- was there an easing at all in the fourth quarter? Did it remain constant, and how do you feel about your competitors looking out into the first couple quarters of this year in terms of their pricing?

Terry, this is Mike. I think it was pretty consistent all through 2006, and I would say as we roll into 2007 it is pretty consistent out there right now that there is not a lot of expansion organically going on in the Michigan economy, and there is a lot of banks out there competing for the same business that we have, so we continue to see some very fierce competition from a pricing and as Jerry mentioned a structure standpoint that I would expect to see probably through at least the first half of the year and what makes it more difficult of course is the flat yield curve we have out there which right now it is a difficult time to find a place on that yield curve when you have competitors out there quoting rates that really don't make any sense in our view, so it makes it doubly tough to come up with the asset growth that we are used to having here at Mercantile. However, we continue to do it. We continue to outperform our peers and the market in general as far as banks go throughout Michigan and in the country because we continue to focus on what we've always done which is try to win the business on strong relationships rather than win it on deal structure or pricing, but when the pricing gap that we're seeing becomes so great, it just makes it tougher to overcome that.

Thank you.

You bet.

Thank you. Our next question is from John Rowan with Sidoti and Company.

Good morning.

Hi, John.

Chuck, can you go through the rates for the maturing CDs again? I didn't get everything.

Certainly, John. For the first quarter of '07 it totaled 260 million at 4.8 average rate. In the second quarter it is 220 million at an average rate of 5.1, and in the last six months of '07 it is 335 million at a average rate of 5.25, and the one-year CD rate currently is about 5.25%.

Okay. And just quickly on the tax rate, there was a jump in the quarter. Do you see it staying at around 32% or going back down to around 31?

This would be somewhere between 31 and 32%. There was an adjustment we put through in the fourth quarter.

And just a follow-up on the previous question, Bob, can you kind of talk about what your expectations are for the provision expense going forward? You expect it to at least match charge-offs?

Well, as I mentioned in the previous question, we go through a calculation every month, and then certainly at quarter end to make the determination what the provision should be, and obviously charge-offs are factored into that equation, but it also looks at all the things going on in the portfolio, loan grading, loan growth, loan grading changes, so it is quite a complex computation that certainly charge-offs is an important factor but it's not the only factor.

Okay. Thank you.

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

Thank you. Good morning.

Good morning, Brad.

One quick housekeeping item. Just kind of compare earnings apples-to-apples versus last year's fourth quarter. Can you remind me, I did my own calculation but what was your options expense in the fourth quarter of '05 if you have that handy?

Brad, I am going to have to get back to you. I don't have that.

Okay. Was just curious about that.

I know it is in our Q in the foot note, but I don't have that with me.

And then just to make sure I heard you right, Chuck, on margin pressure for the next couple of quarters, we can do our calculations based on maturing wholesale CD's and so forth, but it sounded like you would expect the rate of decline to slow a little bit versus the past couple of quarters. Is that right?

Yes. Making the assumption that rates don't change from where they are today, I think the first quarter will show a similar type of decline as what we've seen the last couple quarters, but thereafter we'll definitely see it a smaller decline if not just more of a straight line.

Okay. Excellent.

Obviously a few basis points here and there but.

And then it is pretty clear, we can sense your frustration about some of the competition in the market right now. It sounds like it is fairly irrational. Is it -- and it sounds like it is coming from everybody, or is it smaller banks scrambling to get market share or the bigger banks maybe just trying to post balance sheet growth at any price or is it coming from one place or another?

Yes, Brad, this is Mike. I would say we see it a little bit all the way across the board, but we run into it probably a little bit more with the larger banks that the sense that we have is that they're just trying to stem the bleeding as far as balance sheet run off goes, and we focus a lot on how to run this bank profitably, and we are frustrated because we don't see how they're making money on some of these deals, but I guess that's up to them to decide whether or not they want to continue to do that, but it certainly is frustrating when you see one bank offering a fixed rate for five years in the low 6% and at the same time turn around and offering the same customer on a deposit rate for three years a fixed 5.25, and you don't have to be a genius to figure out that one is a tough to figure out how they're making any money, and it is happening, and it happens out there quite a bit these days, but we continue again to focus on building the relationships, adding the value through that consultative approach that Mercantile always has, but it clearly is an interesting time for sure out there.

And I know you can't necessarily get inside their head, but what does it take to change that? Does it take a credit quality surprise for them or better organic growth in the market? What's going to change that dynamic?

I'll let Jerry, Bob, or Chuck ad to this, but from my view point, it clearly can't, I don't think, in my personal opinion continue forever just because just it makes no sense from a pricing and profitability standpoint. I think it takes a combination of somebody probably taking a look at what is going on to that particular market of the bank that's doing that, credit surprises I think you will see popping up with some of these banks because they're doing deals without guarantees, for example, or under secured that we just walk away from saying we need those guarantees or we need that security, and I think the combination of those things inevitably will pop up. When that will happen, is it Valentine's Day or is it next year, it is hard to get a sense on because it depends on how diligently senior management of these banks at their headquarters sometimes many states away will take a look at it, but Jerry or Bob or Chuck?

Yes, Brad, this is Jerry. I read a lot of the research that you all send me, and the major culprits who are doing this all have significant earnings challenges of their own, and it is puzzling how they're able to justify some of the rate structures that they put together, so I agree with Mike, I think at some point somebody in another city is going to say that's enough. What these banks are trying to do is compete with rate against service that they can't provide, and that's just -- we just have to ride it out basically, and what we tell our investors is we remain very firm in our commitment to credit quality and spread income, and if it slows the growth temporarily then so be it.

Right, right. And then one final thing, Bob, maybe you could elaborate a little bit for me on the credit trend in the quarter. Just why do you not see the increased charge-offs as indicative of a trend? What is a normalized level for charge-offs? And then also within the charge-offs that you had in the quarter, did you see any industry breakdowns that were troublesome?

Well, I think, Mike quoted some statistics in his prepared comments about what our peer group is doing. As you can see in those trends, charge-offs as well as non-performing loans have increased for banks in our general peer group and specifically within this region. I think what you see is a trend toward higher problem loans. Our trends were pretty stable if you look at each of the quarters in 2006 in terms of our non-performing loans. In terms of any particular industries that have been challenged, obviously the automotive continues to be one that goes through major struggles and challenges here in the Midwest and the state of Michigan in particular, and you see some credits exhibiting some stress because of that. The economy as a whole is not extremely healthy here, and until that turns around I think you will still see some performers within those industry groups and other industry groups as well that exhibit some stress.

Brad, this is Mike. Let me amplify what Bob says. Let me give you an example for -- we have one deal in ORE right now, and the deal was a real estate development deal that we got an appraisal on, and we haven't filed for $3.2 million. We made about a $2 million loan on it. The deal went sour because right now real estate in Michigan is a challenge in some cases. We collected $850,000 from the guarantor, so reduced the debt down to slightly over $1 million, took the property to auction, got an offer of about 750,000, pulled it out of the auction, and took a charge to indicate what we think the value is.

You look at that, and you say, boy, where did the lender go wrong or where did the process go wrong, and it is really difficult to say that you did. We ended up with a piece of property that, on appraised as finished completed value should have been worth, according to the appraisal $3.2 million, and you end up with about $1 million debt on it, and it is still a difficult market right now to dispose of that, so that's the type of thing we're seeing in addition to -- there is a lot of stuff that we talked about earlier in the year that was put on the books by a lender who is no longer with us that that was all across the board as far as industry goes, and we're just, I guess in the -- lack of a better term cleaning up a lot of that as we went to the end of the year.

Okay. Okay. And I know you're -- definitely are seeing higher charge-offs and non-performers across the industry. I know you guys are not happy with numbers that are in line with the peer group.

No, we definitely aren't, and we definitely are doing everything we possibly can to get back to Mr. Mercantile-esque numbers.

All right. Thanks very much.

You bet.

Thank you. Our next question is from Eric Grubelich with Keefe, Bruyette & Woods.

Good morning, Eric.

A couple of things, actually just to follow-up on, I think, what Mike was just talking about. You did mention you had that lender who is no longer with the bank. Is there much more to follow from what this guy had done or are you pretty much through the problems?

That's a good question. The good news I think as far as this particular lender's portfolio is that there really hasn't been anything identified, in addition the lender has been gone now for, I don't know, three quarters of a year, and we combed through that portfolio pretty well, and we don't see anything that hasn't been identified that's popped up in the last four, five months, so I think that's pretty good news.

Was the one that example that you just gave about the ORE was that one of his or something--?

Nope. Actually that one was actually just made by a lender who has had a very good track record here and was approved by senior management as well because all the metrics looked good, and certainly everything -- I think in a normal market three years ago the deal would have been just fine, but right now there has just been, as I think everybody is aware of in certain real estate markets there has just been a real shift in what's going on out there. Speaking about the lender that left, I am not sure that we've ever been clear about the gender of the person, and I am not sure we want to focus any more on that, but we'll just leave it at that.

If I said he, I was just speaking generally.

And if we've ever said that in the past, we're just being very generic.

No. I understand. So on that ORE property, though, was that a commercial or was it residential?

That's commercial. It's a commercial property being -- it was being developed into some residential. The end use was going to be for some residential lots, but certainly a commercial development project.

Okay. And what -- was there anything else of significance that filled the NPA bucket up after you took a couple of million of charge off?

I think it was just a lot of stuff that as we worked it through the course of the year we looked at and said, let's try to be conservative as we always are here at Mercantile, and if we think that there is a pretty good chance of a loss, then let's take it, and then try to, as we go through the collection process, recover some of that in the future.

Mike, do you think in '07, then, that the -- I know the intention is to get the charge-off and credit numbers down to I think as you put it more Mercantile-esque levels. Do you think it is still going to be a little bit of a tough situation here going into '07 before that happens?

Yes, when I say Mercantile-esque, I look back to a couple years ago, and for everybody that's been following us quarter after quarter, I think when we had 0.03 non-performers, I always said that's a pretty amazing number. That will not always be that way. Are we going to get back to 0.03 or 0.09 like we were for many years in the quarter, no, but I really feel good about the fact that we're not identifying any more. As I mentioned last quarter, the watch list totals have come down, and that's always a good indicator of where charge-offs are to follow a couple of quarters down, but are you going to see 0.46 NPAs become 0.21 at the end of the first quarter, I don't think so, but are you going to see that number increase significantly? I don't think so on that end either.

I think what we're probably, those of us on the phone are just looking at -- it seems to me that you're characterizing the fourth quarter as a difficult environment but also some clean-up and that we wouldn't necessarily expect to see a 50 basis point run rate on charge-offs going forward.

Right.

But on the other hand it is not going to be 10 basis points either.

Right. I would say that's a pretty good characterization of where we feel things are.

Okay. And then I think you had made a comment earlier off the asset quality subject about the margin, and I thought you said, again talking about the competitive environment and irrational pricing, irrational terms, what in your mind is making you think that the pressure -- let's put it this way, not necessarily the margin, price competition for loans, what makes you think that it is going to turn the corner in a few quarters? Putting the yield curve aside for a minute, what do you think is going to change in the competitive landscape that may ease that burden of price competition in loans or in lending?

I think -- we're not saying that we absolutely know it is going to change in a few quarters, but intuitively as entrepreneurial business people, we just see how difficult road ahead for this particular type of pricing and particular type of method of operation to continue. One of the things that we do have hope is that the yield curve will change somewhat because that does cause a bigger part of a problem is that a lot of our competitors are clearly guessing and hoping that as they, quote, for example a five-year fixed rated term loan at 5.75 or 6.25 when prime is over 8, they clearly are betting that that yield curve is going to change and that rates obviously are going to come down. I think, what are the odds that the yield curve is going to be flat a year from now? I guess if we all knew the answer to that, we would probably be happy, but it is probably going to change somewhat, but I don't think that these other banks are positioned to continue to make these bets over and over and over again, but they could, and we're planning for that, and the way we plan for that is to continue to stick to our knitting and say, we're still able to grow, we're still able to get new business because of service levels and the relationship building that we are building our bank on. We still lead the pack in that, and we always will. That's what we're all about. It just makes it a more difficult environment for us to operate in.

Yes. Okay. And then a question for Chuck related to the margin. Chuck, just generally speaking, if you can sort of weight it a little bit or weight the answer a little bit, then I am going to ask you at least a question. When you look back at the margin this past year, in your mind, given your unique funding structure that's more wholesale oriented than the typical bank, when you look at where the margin compression has been, roughly how much of it would you say is due to the competition on the pricing versus -- of the loans versus the general impact of the yield curve in your relationship of your prime-based loans and your funding.

Certainly a vast majority is just timing. It is just our cost of funds catching up, as we price down the fixed rate liabilities that we have. I don't know how to venture a guess to that, 10, 20%.

Okay.

That would just be my guess on that. We certainly never tried to put a pencil and a calculator to it but that's part of it.

Typically you have, being more of a prime-based lender and again given the structure of your liabilities, you have got a natural spread between prime and wholesale borrowing, and I guess it sounds to me what you're describing on those roll rates in the next couple of quarters and the second half if the market really doesn't move, you should not be getting a lot more pressure after the first or maybe after the second quarter from the funding side of the equation.

Correct.

Okay. So the competition on price is of course the big question, if that persists or not as Mike was just talking about.

You certainly -- you and I can, we can do the number crunching to figure out just the repricing and how that impacts the margin, but certainly the wild card is going to be not only the competitiveness as we talk about but certainly the shape of the yield curve as well. There is just -- rates are pretty much the same regardless of the term you take currently right now, so there is not really a lot you can do from a management standpoint of trying to help the current margin, but certainly what we do and as we do in any rate environment at any time is look at our balance sheet for the next 12, 18, and 24 months and try to position the balance sheet to take into account any changes in the interest rate environment itself, so we're certainly looking out into the future and trying to position the balance sheet appropriately.

Right. And then just one last question for Jerry. Jerry, have you or I guess has the Board looked at what the non-lender bonus boggy is for next year, yet?

Yes. We are looking right now, actually in the process of looking at our total bonus plan both for non-lenders and lenders, and I am really not prepared to discuss it any further, but--.

That's okay.

We certainly are sensitive to not paying a bonus. We're also sensitive to paying a bonus if we're not producing for our investors, so we're trying to balance both of those and come up with a plan that we feel is fair to our shareholders and at the same time recognizes outstanding performance of our employees.

Sure. No, no, thanks for all of the candid answers to the questions. It is appreciated.

Thank you. [OPERATOR INSTRUCTIONS] Our next question is from Steve Covington with Stephens Capital. Please state your question.

Good morning, guys.

Hi, Steve.

All of my questions have been answered. I did have one just kind of question out of curiosity. Bob, you mentioned the HSA product that you've begun to get some traction in. I just wonder if you could maybe give a little bit of color to the opportunities you see there and I wasn't sure if I heard exactly the number of accounts and the balances and what you think that could end up becoming for you guys.

Yes. You bet, Steve. This is something really we took great initiative on in 2006. It is a new product. I think people in the community are just becoming aware of what this product can do for them, and as well as employers, and so we really establish a great relationship with one of the large employers in this area, the latter half of 2006, that allows us to put a big push on, and we opened in the last couple months of the year about 700 new HSA accounts. These accounts are still in the process of funding as we speak, but within those 700 accounts are 700 new customers that present some cross-selling opportunities, some other chances to get them to know Mercantile Bank, many of whom do not bank with us and so they're brand new customers, potentially multi employer as well as the individuals with the savings accounts. So there are numerous opportunities there with this product, and we see it as something that we will continue to really emphasize to our staff and look for opportunities as they're out there talking to businesses and seeing what types of plans they have for health insurance for their employees. So this has been a real nice product for us and we'll continue to stress that as we go into '07.

And isn't the opening cycle for these accounts typically in January, and I guess would you expect that number to get bigger just even from the couple of relationships you have?

Yes. Absolutely. Obviously the timing on these things are typically pivoting around year end, but as we go throughout the year, establishing new relationships with other employers and look to start to fund these accounts as we go through the year, and as I mentioned I think we're able to double basically our HSA accounts in the latter half of the year with this other relationship, so great possibilities there, and it is one that I think people continue to gain awareness on and the more they do, the more opportunities there will be out there.

Thanks, guys.

Thanks, Steve:

Thank you. Our next question is from [Steven Guyan] with Stifel Nicolaus. Please state your question.

Yes. Good morning. Just a couple of questions. I apologize if these have been answered already. I was a little bit late to the call, but as far as asset sensitivity, are you still asset sensitive and if rates would go down, say 25 basis points in the next few months, what impact would that have on the margin?

Steve, this is Chuck. We're pretty well matched kind of regardless of what the interest rate environment does. We do expect as wev'e talked about, our margin to go down a little bit just from some of the repricing. As far as the GAAP terminology of asset sensitive, liability sensitive in the short haul we are assets -- we remain asset sensitive. We still have, excluding caps right now about 70 -- almost 70% of our loans are still tied to prime. If you factor in the caps, you look at a potential increasing interest rate environment our floating rate loans are probably in the low 50%, so that would certainly have an impact, but on the short term we're definitely still asset sensitive. If you start linking that out over a twelve-month period, say, then we have a lot of the fixed rate CD products and other things that come into play, and we're probably a little more liability sensitive out for a whole year.

Okay. And also with loan growth, you said the pipeline it looks pretty good. Can you kind of break that down by geography, where you're seeing the positive growth?

This is Mike. I think we're seeing it all across the board. Lansing was particularly strong for us last year and they continue to indicate that they've got a lot of really good stuff in that pipeline, if you will. Grand Rapids of course is always very strong for us, but even Holland and Ann Arbor were a little softer than what they would have liked last year are showing some good activity levels, so I don't really look at any one area to take a disproportionate lead into it, but we've got some good stuff going on in all of the markets.

Okay. And last question, as far as expenses for 2007, where do you see that going?

On the overhead?

Yes.

Okay. I think that we didn't do a lot of hiring and facility expansion in 2006, certainly not to the degree we did in 2005. We certainly have budgeted for some additional staff members in 2007, probably along similar lines of what we did throughout 2006. As Bob mentioned we are scheduled to open up our new Lansing facility in the spring time. That will add a little bit in overhead costs. Those facility costs will be more expensive than the current lease facility that we're in now, but I would say overall we're not looking for some significant increases in overhead costs for 2007 over 2006.

Okay. Thank you.

Thank you. Our next question is from Terry McEvoy with Oppenheimer. Please proceed with your question.

Hi. Just curious on the statement in the press release about the margin challenges threefold, one of them being the uncertainty associated with the direction of rates. Is that being driven by your customer base and maybe an unwillingness to put on a new loan or is it just internally trying to hedge your interest rate position given the uncertainty that you're seeing?

I think, Terry, this is Charlie, I think it is probably all of the above. I think as we meant in the press release there is a lot of uncertainty just in the whole marketplace with the -- with what the rates environment is going to be six months from now, twelve months from now, certainly with the flat to inverted yield curve, the bond market, medium and long-term rate environment, certainly is looking for the Fed to start cutting rates, but you read the press release from the Fed, you look at their comments that they make in their regular speeches, and it doesn't look like, at least to us that the Fed is going to start cutting short-term rates any time soon, and that just causes a lot of confusion and questioning not only on our part but our customer's deposit and is borrowers alike, and who knows what's going to happen, and trying to manage that whether it is the Bank or whether that's our customer's just provides some difficulty in the expectations and what to do with it.

Thanks. Just a question for Jerry. I think it was in November you mentioned in a conference a willingness for Mercantile to possibly pursue bank acquisitions, and do you see the Bank maybe putting that growth strategy on hold until some of the challenges that you've been very up front with today discussing until those challenges possibly ease or do you think an acquisition is completely separate from the margin challenges, et cetera?

I think they're very much tied together, Terry, and certainly if we had an opportunity in another market either through acquisition or de novo, I think the four of us would have to take a look at it, but we do not have any plans at this time to do anything but continue to grow the markets that we're in and make sure we have our asset quality numbers where we want them and work with the pressures that we're going to have on spread and margins, so it would take a very unique situation I believe for us to go into any other markets this coming year. Now, that being said, certainly going forward in 2008, 2009, whatever, we want to be able to take a look. But I think you're very accurate in this question because I think for this year we are really going to concentrate on the markets that we're in.

Appreciate it. Thank you.

Thank you. Our next question is from Jon Arfstrom with RBC Capital Markets. Please state your question.

Good morning, guys.

Good morning.

Sorry to belabor the call here, but I have got a couple of questions. Chuck, do you know what the bonus expense would have been had you hit the 15% growth?

Yes, Jon. It is about 2.9 million.

2.9 million. Okay. And is that something that you would typically accrue in the first quarter?

Yes. What we do is formally on a quarterly basis -- what we certainly look at on a monthly basis is we look at our historical performance within that given year, reproject internally what we think is going to happen for the rest of the year and make an appropriate accrual based on the historical numbers as well as our expectations. The bonus is not all or nothing. It does provide for pro rata payments so our accrual could be adjusted for that.

But the 2.9 million you're saying was the full bonus number?

If we would have had our full bonus bogey for 2006, yes, that is the expense that would have been -- gone through.

So what was the number actually that actually flowed through for the full year?

The full year for the non-lender bonus program was zero.

Okay. Great.

Easy for you to say.

Well, I was going to make a comment offline with you that having a bonus accrual at lower than 15% is definitely acceptable in this type of environment, but we can talk about that offline, but loan growth outlook, I know we've talked about this quite a bit, but do you feel like is it stable? Is it decelerating? Can you get -- we have a 2.1% sequential growth number, and that's down two quarters in a row. Can that move back up early in '07?

Yes, I think it can, Jon. This is Mike. I think we've got some good stuff out there that -- the wild card is we had some unusual, for us anyway, some large pay offs during the fourth quarter because in many cases we had some large real estate -- commercial real estate deals that our customers did really well on and they sold them and the debt got paid off, but that's pretty unusual for us, so I think it is very, very possible that we get back to the normal number for us anyway which is pretty robust loan growth.

So if you really, if you strip all of this to its core, you really have potentially a couple of quarters of margin pressure, and maybe loan growth that's not quite at your historical levels but still relatively strong, but it seems like when you strip it to its core the margin is really the issue in early '07. Is that fair?

Definitely. You're right on, Jon, especially with making comparisons to 2006.

Okay. Okay. Jerry, just one question for you. I hope you don't take it the wrong way because there is no hidden agenda here, but are you satisfied with the results for the year given the environment? I know we touched on the bonus issue, and that's somewhat of a sensitive topic for everyone, but given the environment are you satisfied with the year and are you generally optimistic for '07?

I don't think any of us are what you would say satisfied when you compare our performance this year which is by peer standards is still very good. Am I satisfied by the way our employees performed and the way our management team performed? Absolutely. We faced a lot of challenges this year. Yield curve, some loans made by some people that the loans shouldn't have been made, and this isn't making excuses, but would I like to have seen an earnings per share increase of 15% and a full bonus payout, absolutely. Would I like to have seen -- and not just for the four of us sitting here. I am talking about the bonuses for the people who work so hard every day to make us such a great organization, but am I satisfied with the way that our people responded and the way we met the challenges? Absolutely. I would match this group against anybody I have ever worked with. I would like to see better numbers, but I am very pleased with the way our team performed, and that's kind of an ambivalent answer, Jon, but you have to kind of divide it into two parts, I guess.

All right. Thank you.

Thank you. Gentlemen, we have no further questions.

All right. If that's the case thank you all very much for dialing in. That concludes the conference.

Thank you, sir. Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time. Thank you all for your participation and have a wonderful day.