Mercantile Bank Corp (MBWM) 2008 Q2 法說會逐字稿

Good day, everyone, and welcome to the Mercantile Bank Corporation second-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 plan 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 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, www.mercbank.com.

On the conference today from Mercantile Bank Corporation, we have Mike Price, Chairman, President and Chief Executive Officer, and Chuck Christmas, Senior Vice President and Chief Financial Officer. 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. Price. Please go ahead, sir.

Thank you. Good morning, everyone, and thank you for joining us today. Our second-quarter results were severely impacted by the continuation of the credit crisis that has been in full bloom now for the past few quarters. While our provision for loan loss was significantly lower than our first-quarter provision, it was still higher than what we were expecting, but necessary to maintain our conservative posture and a healthy reserve ratio for possible loan losses.

As usual, today, our CFO, Chuck Christmas, will give you a summary of the financial data for the quarter. Bob Kaminski is on vacation this week, so after Chuck's comments I will give you some more color on the asset quality situation. Chuck?

Thanks, Mike, and good morning, everybody. What I would like to do, as typical, is give you an overview of Mercantile's financial condition and operating results for the second quarter of 2008 and the first six months of 2008, highlighting the major financial condition and performance balances and ratios.

On our earnings performance, we recorded a net loss of $2.6 million or $0.31 per share during the second quarter of 2008 compared to net income of $2.2 million or $0.26 per share during the second quarter of 2007, but an improvement from the net loss of $3.7 million recorded during the first quarter of 2008.

We recorded a net loss of $6.4 million or $0.75 per share during the first six months of 2008 compared to net income of $6.5 million or $0.77 per share during the first six months of 2007. The decline in earnings performance during 2008 is primarily the result of a significantly higher provision expense and a substantially lower level of net interest income.

The higher provision expense reflects the broad deterioration of the quality of our commercial loan portfolio as state, regional and national economic struggles have had a negative impact on some of our borrowers' cash flows, and the reduction of collateral values. The lower level of net interest income primarily reflects the impact of a steep decline in interest rates that began late in the third quarter of 2007.

With our near-term asset sensitivity position, whereby we have a higher magnitude of assets subject to repricing when compared to the level of liabilities subject to repricing, combined with an increased level of nonperforming assets, along with a very competitive loan and deposit environment, we have experienced a decline in the level of net interest income which has more than offset the growth in our earning assets.

Our net interest income during the second quarter of 2008 totaled $10.6 million, a decline of $3.3 million from the $13.9 million earned in the second quarter of 2008, and net interest income during the first six months of 2008 totaled $22 million, a decline of $6.4 million from the $28.4 million earned in the first six months of 2007.

Average earning assets equaled $2.03 billion during the second quarter of 2008, an increase of $64 million from the level of average earning assets during the second quarter of 2007. As usual, the growth in earning assets was led by growth in total loans, which accounted for about 90% of the growth in earning assets.

Our net interest margin during the second quarter of 2008 equaled 2.15%, down from the 2.33% margin during the first quarter of this year to the 2.64% level recorded during the fourth quarter of 2007 and the 2.86% level recorded during the third quarter of 2007. The 71 basis point drop in our net interest margin since the third quarter of 2007 primarily reflects the steep decline in market interest rates that started with the collapse of the subprime residential real estate markets during late summer and fall of 2007. From mid-September of 2007 to late April 2008, the Federal Reserve lowered the Fed funds rate, and thereby the prime rate, by 325 basis points.

With about 60% of our loans tied to floating rates, we have experienced a significant decline in our yield on assets. Our asset yield is down about 150 basis points since the Federal Reserve's first rate reduction, led by a 180 basis point decline in the yield on our loan portfolio. Current market sentiment is that the Federal Reserve will likely leave rates unchanged in the near term, under which forecast we would expect our current asset yield to remain relatively steady.

We have also seen a significant reduction in our cost of funds, but just not to the degree of the decline in our asset yield. Our asset yield has gone down by 150 basis points since September of 2007. Our cost of funds has declined by about 80 basis points. While deposit and borrowing rates have declined, our relatively high reliance on fixed-rate certificates of deposit and Federal Home Loan Bank advances resulted in a lagged reduction in our cost of funds.

With about $465 million of relatively high-rate wholesale funds scheduled to mature during the remainder of 2008 and another $520 million maturing during 2009, we do expect our cost of funds to continue to decline throughout the remainder of 2008 and into 2009. These maturing funds carry interest rates that generally range about 75 to 125 basis points above current interest rates.

Given the multitude of factors that impact the net interest margin, such as Federal Reserve decisions, corresponding changes in interest rates for deposits and borrowed funds, shape of the yield curve, loan and deposit competitive environment, changes in balance sheet structure, level of nonperforming assets, and potential changes in interest rate risk management strategies, it is difficult to predict the future net interest margin. However, under the current interest rate environment, our net interest margin will begin to significantly improve as we move into the second half of 2008 and into 2009.

The provision expense during the second quarter of 2008 totaled $6.2 million, an increase of $3.8 million over the $2.4 million expensed during the second quarter of 2007, although an improvement of $2.9 million from the $9.1 million expensed during the first quarter of 2008. The provision expense during the first six months of 2008 totaled $15.2 million, an increase of $11.8 million from the $3.4 million expensed during the first six months of 2007.

Our loan loss reserve totaled $31.9 million as of June 30, or 1.73% of total loans. Our loan loss reserve equaled 1.67% of total loans at the end of the first quarter of this year and 1.28% of total loans a year ago. Mike will have specific and more detailed commentary on asset quality after my prepared remarks.

Our noninterest income totaled $1.7 million during the second quarter of 2008, an increase of $0.3 million or about 24% from the $1.4 million earned in the second quarter of 2007. Noninterest income totaled $3.6 million during the first six months of 2008, an increase of $0.8 million or about 29% from the $2.8 million earned during the first six months of 2007.

We recorded increases in virtually all fee income categories. During the first six months of 2008 compared to the first six months of 2007, service charge income was up about $202,000, mortgage banking income was up about $199,000 and bank-owned life insurance policy income was up $247,000.

Noninterest expense totaled $10.8 million during the second quarter of 2008, an increase of $0.7 million over the $10 million expensed during the second quarter of 2007. Adjusting for the onetime $1.2 million expense associated with former Chairman Johnson's retirement package that was recorded during the second quarter of 2007, the increase in 2008 over 2007 was $1.9 million.

Noninterest expense totaled $21.1 million during the first six months of 2008, an increase of $2.3 million over the amount expensed in the first six months of 2007. Again, adjusting for the onetime expense during 2007, the increase in 2008 totaled $3.5 million.

The majority of the noninterest expense growth during the first six months of 2008 when compared to the same time period in 2007 relates to costs associated with the administration and resolution of problem assets, including legal costs, property tax payments, appraisals and writedowns on foreclosed properties. These costs totaled $1.1 million during the second quarter of 2008 and $1.5 million during the first six months of 2008. During the first six months of 2007, these costs totaled only $0.2 million.

Writedowns of foreclosed properties comprised the majority of the cost, equating to $0.7 million of the $1.1 million expensed during the second quarter of this year and $0.9 million of the $1.5 million expensed during the first six months of 2008.

One other expense item of note is the increased FDIC insurance premium assessment, an increase of $0.5 million during the first six months of 2008 when compared to the first six months of 2007.

Our funding strategy has not changed significantly as we continue to grow local deposit and bridge the funding gap with wholesale funds, namely brokered CDs and Federal Home Loan Bank advances. Our average wholesale funds to total funds during the second quarter of 2008 was 63% compared to 61% during the first quarter of this year, with the reduction -- or the increase primarily reflecting funding our asset growth and also less public unit CDs.

Given the lower interest rate environment on Federal Home Loan Bank advances when compared to the brokered CD market, we have replaced some maturing brokered CDs with Federal Home Loan Bank advances. Federal Home Loan Bank advances have increased $150 million over the past 12 months, including $105 million during the first six months of 2008.

We remain in a well-capitalized position per bank regulatory definitions, with a consolidated total risk-based capital ratio of 11% and a bank total risk-based capital ratio of 10.8% as of June 30 of this year. The bank's total regulatory capital equaled about $225 million at the end of the second quarter of this year, approximately $17 million in excess of the amount needed to provide for the 10% minimum well-capitalized total risk-based capital ratio.

That is my prepared remarks. I would be happy to answer any questions in the Q&A session, but now I turn it back over to Mike.

Thanks, Chuck. Regarding asset quality, which, along with margin improvement, continues to be our main focus, the second quarter saw our nonperforming assets increase by $6 million to $46.6 million or 2.16 of total assets. During the quarter, we placed $15.5 million in new loans in nonperforming status. We collected $4.6 million in paydowns and took $4.9 million in charge-offs or ORE writedowns.

As far as a breakdown of what is in the nonperforming assets by loan type, $12.4 million is residential land development loans, $3.5 million is in commercial land development, $2.3 million is in one-to-four-family construction, $3.2 million in one-to-four-family housing, $7 million in commercial owner-occupied, $10.2 million in commercial nonowner-occupied, and $8 million in the C&I category. During the quarter, the largest net increase occurred in the category of commercial land development of $3.5 million, and the largest decrease occurred in the category of commercial owner-occupied of about $2 million.

The majority of the $15.5 million addition to the nonperforming assets came from eight relationships, all of which had been previously identified as watchlist loans. As of quarter end, about 40% of our nonperforming loans remained contractually current. None of these current customers remain current through funded interest reserves. But despite the current status of these current loans, management feels that conditions point to potentially serious issues with cash flows in the near future.

The fourth quarter of 2007 was a period when we recognized the potential for loss in our residential real estate development area. The first quarter of this year saw an increase in commercial real estate and some C&I downgrades. This quarter, the theme really was largely centered on downgrades and chargedowns on previously identified relationships, where new appraisals and/or the liquidity of guarantors have demonstrated significantly lower values or capacity.

While the continual erosion in real estate values has been a source of frustration and estimating embedded losses within the loan portfolio, we have seen some recent indications that we may be nearing the peak in our nonperforming asset level.

Positive trends in our watchlist totals and positive trends in the past-due-30-to-89 loan categories have shown improvement during the quarter. We're seeing fewer new credits added to the watchlist, and the totals for the past few months have trended downward.

As additional color, it is interesting to note that our accruing 30-to-89-day past dues totaled only $1.4 million at June 30. This is the lowest that total has been since early 2006 and compares very favorably with the March 31 and December 31 totals of $3 million and $7 million, respectively. Past history has shown that the vast majority of nonperforming assets and losses migrate from the past due and watchlist totals.

While there certainly remain challenging headwinds within the marketplace and our performance was not what we had planned for, for the first time in four to five quarters, we are more encouraged than discouraged as to the direction of our asset quality numbers in the short term. In the meantime, we will continue to manage our balance sheet from a well-capitalized position, keep overhead cost well managed, continue to work on building a stronger margin, and keep a strong focus on reducing those nonperforming assets.

At this point, we would like to open the lines for questions.

(OPERATOR INSTRUCTIONS). Stephen Geyen, Stifel Nicolaus.

I am just wondering if you could discuss one more time the watchlist, the trend in watchlist credits and then the amount of 90 days past due?

What was the second part, Stephen? Sorry?

And what was the amount of the 90 days past due?

Yes. The watchlist totals during the quarter started out very stable, and towards the end of the quarter, we actually saw some fairly nice reductions in the total amount of loans on the watchlist, the first time that that has happened in probably over a year, maybe well over a year. And that has continued on into the quarter here as we are starting to see some resolutions, starting to see some credits actually being upgraded.

As you know, we have been very, very aggressive in putting anything that we saw weakness on, nonperforming in the watchlist, and some of these situations fortunately have turned around or have been resolved and we have been able to move them out of the bank.

As far as the 30-day to 90-day past dues, I don't have them broken down by category, but the majority of those were in the 30-day total, and the total of all three categories was $1.5 million, which, as I said before, is significantly below the $3 million that it was at the end of last quarter. And in December, it was $7 million. And it was at that $7 million total for most of the last few months of '07. And we haven't seen numbers that low since early '06.

So we are feeling pretty good that we finally have seen some numbers that would indicate that the new stuff that is coming into either the watchlist and/or past dues has started to drop at a fairly significant level. As I said in my comments, the quarter really felt like we had finally gotten our hands around and quarantined the problem loans, and almost all of the losses, although they were more than what we expected, came from that list. And we've just continued to beat that list down and down and down.

And it has been frustrating, because we've got, in some cases, two or three new appraisals, and obviously with what is going on out there, we felt it prudent to write it down to what the new appraised values are, or there's been a couple of situations where we had this year, or this quarter, some guarantors who have been pretty well-heeled and have been making some payments just run out of that liquidity.

So if there is any good thing we can take out of what happened in the quarter on the asset quality side, it is the fact that very few new names are being added to the list, and we continue to write down the problem loans at a real aggressive pace.

And do you have any idea of what the value of the loans are that are currently working through the interest reserves of those loans that are not performing?

Well, that is what -- my comment earlier meant to address that. So I appreciate you asking the question so I can make it very clear, is that we have none of the loans that are past due or on the nonperforming list have any kind of interest reserve. I know that was a big article, and rightly so, that the FDIC was very concerned about that. It appeared in the New York Times. But we are not holding any credits or there's no credits in the portfolio that we're concerned about that are staying alive by funded interest reserves.

Eileen Rooney, KBW.

I just had a question related to what you said, Mike, about the second quarter was all about downgrading previously identified credits. How much would you say you have written down, mostly the nonperformers, say, in the residential development portfolio?

You know, what we have done, we have been, again, pretty aggressive, like during the quarter, of the $6.2 million in provision we set aside, $1.8 million of that was in further downgrades of stuff that we'd already had identified as problems, either on the watchlist or in an NPA from quarters past. So there were some significant downgrades in those areas.

As a percentage, it really varies depending upon loan by loan. We got rid of some NPAs during the quarter that we did not discount at all. We were able to sell them because of where they were and the values. But we have had two or three deals where we were 80% lent on a deal, according to the original appraisal, and we have written them down by 50%, sometimes even more.

Okay, that is very helpful.

Jon Arfstrom, RBC Capital Markets.

Chuck, a question for you on something in your prepared comments. You said $1.1 million of the expense line was from the cost associated with problem assets. I think it was, if my math is right, it's pretty easy, but $400,000 in the first quarter.

Correct.

How much of that $1.1 million would you say is perhaps one-time in nature, and how much of that lingers on into Q3 and Q4?

Of the $1.1 million, for the quarter, about $700,000 of that is associated with writedowns of foreclosed properties and kind of dovetails to what Mike was just talking about with some of our nonperforming loans. And we certainly continue to reevaluate those properties at least on a quarterly basis, quite friendly even more readily than that. And hopefully, we're getting towards the bottom of some of these valuation degradations.

We certainly believe that as of June 30 that we've got our other real estate owned properties marked down to what our net sales price is going to be. And obviously only time will tell as to how accurate we are, but we have tried to take an aggressive or conservative approach when making those writedowns.

Can you touch a bit on the asset quality trends in commercial mortgages, so the nonconstruction and development, and then also the straight C&I loan book?

Sure. This is Mike again. As far as the nonresidential commercial CRE, we are not seeing a lot of new issues coming up in there. That has been holding in there pretty well. Fortunately, we put about $1.7 million in provision this quarter, and it was largely three deals that we had already had as nonperformers. They've come back with new appraisals, and we just downgraded them and put some estimated loss -- further losses on them.

So the bad news is that obviously some of those values are even further eroded, but those three particular credits have been written down now to some pretty darn low values.

The C&I, again, these were -- there were one, two, three -- there was about four or five large deals in the C&I downgrades. They were all deals that were either already on the watchlist or already in the NPAs. And a couple of them are current, but again, we see reasons to see weakness in them. And we thought it prudent to further write them down.

It goes back to my earlier comment, though, that so many of them that we saw this quarter, almost everything we saw this quarter, came from existing deals that we have identified, and the number of new credits added to the watchlist in the quarter was extremely small. And that, combined with the number of the new past due loans, gives us a lot of optimism going forward.

Just a couple more here. In terms of the loan pipeline, I know that this is not the environment for the Mercantile of old in terms of quarterly loan growth, but you made some comments in the press release about some competitive pressures waning. And theoretically, with some of the watchlist credits coming down, I guess the question is, is there an opportunity to continue to grow the Company perhaps at a bit faster pace than we've seen over the last few quarters?

There certainly is that opportunity to build loan totals. Whether or not we take that opportunity is going to be a question of capital used in the appropriate way. The good thing about it is that for the first time in a long, long, long time -- we've been talking on these calls about rationality coming back to deal structure. Well, all of the sudden, we've seen, which is a welcome thing, rationality coming back in loan pricing.

Some of our biggest competitors are basically out of the commercial real estate business. And we certainly aren't there to become the largest strip mall and CRE lender in the United States, that is for sure. But clearly, the opportunity now for those selected relationships that we would like to take is there, and the better part of that is that the opportunity to price them correctly is there because there's just a lot of people out of the market now. And that is a real positive going forward.

The loan growth that we did have in the last quarter was -- a lot of that was significantly good C&I stuff that we put on the books, and very, very strong performing credits, and very glad to get those on.

And then just one other question about the geographies of your Company. Do you feel like there's any difference in terms of the economic strength in Grand Rapids compared to Lansing and Ann Arbor?

There's clearly differences in the markets. The nice thing about being relatively new in Lansing and, for example, Washtenaw and [Ovi] is that even though the east side of the state is depicted as being horrible and that type of thing, Oakland County, for example, in Ann Arbor has some pretty good economies going over there, relatively speaking.

So we haven't seen anything that would indicate that there is significant issues with any of those economies and marketplaces that we're involved in over there. A lot of people scratch their head and say, gee, why did Mercantile go into Lansing? But that particular location for us has done extremely well with deposits and loans, and they have a very, very low NPA number there. So a lot of it is, again, the ability to attract good people and the ability to stay away from the bad particular loan types that have been plaguing us.

Okay, great. Thanks for the help.

Michael Cohen, SuNOVA Capital.

Can you talk about any kind of credit tightening you are doing on the loan growth? In addition to getting wider pricing, are you requesting higher loan-to-value or tighter underwriting, as the case may be?

Yes. I think you are probably asking, are we asking for a lower loan-to-value, but I understand what you mean. We are. Certainly, we have taken an opportunity over the last couple of years to do a lot of self-examination to see what we could do to make not only our underwriting criteria stronger, but the way we prosecute putting loans together and getting out there through approval process, and we have reduced some individual lending authorities. So that forces more stuff to bubble up, if you will, in through the loan committee process and to senior management and to the Board.

So I think those things have helped greatly. We have looked at tightening up the way that we monitor any type of borrowing formulas or any type of past due property taxes. Whereas in the past we might let some of those go because everybody has a story, if you will, we really are starting to move more and more and more towards, and in a lot of cases we have done just the zero tolerance. This is the way it is going to be, and that has helped us greatly in the short term.

And then I just wanted to get clarity. You were talking about some of the C&I credits and so forth, and I noted in the last sentence of the third paragraph on asset quality, you said commercial nonperforming assets were roughly $29 million at June 30 compared to $23 million at March 30, 2008. Is that all commercial, or is that intended to imply commercial and industrial? What is driving that $5 million delta? Because it doesn't seem like that would include the land loans and stuff.

Yes, I would have to go back -- yes, Chuck's saying, yes, that is just the commercial portion of the NPAs.

Okay. So that would seem to be a fairly sizable increase, no, or--?

There have been some sizable increases through there. And again, as we talked about, they're ones that we have had on the watchlist, the ones we have been watching, and we haven't seen anything new pop up on the watchlist, if you will, to replace them, fortunately.

Great, that is good news. And then, can you talk about what you are seeing in terms of the local economy and the impact of higher fuel prices in talking to some of your commercial customers and how they are thinking about it impact some of their businesses? Have they passed on price increases to customers? Are they expecting price increases from their suppliers? Can you talk about what you think that is going to mean, or how it has or hasn't yet translated into the numbers?

That is a great question. It is really the question of the day out there within our commercial customers. And quite honestly, there are some customers -- first of all, I should say just about everybody is impacted by higher commodity prices one way or another. As bankers, you learn about how many things are part of somebody's cost of goods that are made out of oil or oil derivatives.

But the interesting thing is, and I guess the challenging thing is that there are certain industries that are much more flexible in allowing our customers to gain price increases. And those industries obviously, as you might imagine, we've got customers that are doing very, very well in recapturing those costs.

There are other industries, transportation being one, and some other industries that it is a trickier deal. It is a little harder. It is not as traditional to see the fuel surcharges, for example, recaptured. And even when they are recaptured, it has impacts on our customers, because they may get the fuel surcharges three months down the road reimbursed to them, but meanwhile that means they need a larger line of credit, larger interest expense and that type of thing.

It is a very fluctuating, fluid dynamic environment out there and one that really requires us to, A., sit down with our customers on a very constant basis and say, look, how is this affecting you? What are you doing about it? And for us to make the tough calls. And if they are not doing enough or if the market just isn't allowing them to recapture those things is to try to move them down or out of the bank. And that is a tough deal.

Then we sit down with the ones that say they can, and you kind of ride with them a little bit and watch how it impacts them. As far as new credits go, that is one of the first questions we have for everybody that walks into our -- show us what the impact is, tell us how you're dealing with it. And that is one of the highest, I guess, on your list of credit metrics, that has probably risen to be one of the highest and first five questions we ask somebody today, is what is going on in that part of your business?

Okay, that is very helpful. And then, just to follow up on Eileen's question, because I wasn't entirely clear, in terms of kind of loss severity on construction credits, what are you averaging across the board, if you will, in terms of kind of your total write-off, not necessarily what you had, what you are taking today, meaning, in other words, what you might have taken in the past plus what you may take at this given period? What is the charge-off to the original principal balance?

We haven't -- I think I know what you're asking, and it's a good question. But we haven't sat down and said, okay, here's the losses we have taken, and let's divide it by the original gross loan and come up with an average. And the reason why is we don't think there's a real correlation there, because, as I mentioned earlier, there are some projects that we are getting back that we're getting out of without taking a loss. We get people that -- and you might imagine, those, for example, in commercial real estate, those with high occupancy levels where something has gone wrong with the borrower, maybe with another project and another issue or whatever, those that have higher levels of occupancy are fairly easy to still get rid of on the marketplace. But as those levels go down the scale, you start taking bigger and bigger hits, as you might image.

So there are sometimes we have gotten out whole. There's times, a whole lot of times, where we take 5% to 10% haircuts. But there are times, and we talk about this quarter, where we've got two or three severely impacted projects that we have written them down by 50%.

Understood. But if you were to sort of narrow that focus simply to construction and development/land, could you provide some perspective on just that narrow category?

Yes. You have the same dynamics with that narrow category. But certainly, I think today what you are seeing land development and construction that is in a nonperforming situation is anywhere from 10% to 15% on the low end, some of those projects.

Okay, great. And then last question -- I can imagine regulatory discussions just across the industry are becoming much more detailed and lengthy. Can you characterize sort of your regulatory discussions or at least when you completed your regulatory exam?

Sure. I will give you back to Chuck in a minute to give you some of the granularity on that, since he has some of the significant conversations and can probably remember the date they left here better than I can.

But I will tell you, that is -- clearly, making sure that we remain in an extremely well-capitalized position is one of the main reasons why we cut the dividend, obviously. And we are very, very focused on managing the bank so that we remain in that position, because of -- you are exactly right -- that's the big subject of the day out there for all financials. And Chuck, I think, could probably give you some more clarity on your other part of the question.

As all banks, we're examined annually. We traditionally have our examination late in the fourth quarter of each calendar year. So they love the bank, and met with the Board in the early part of the first quarter, and no disagreements or anything like that. Certainly, banks are obviously getting examined on an ongoing basis. We obviously talk to other bankers, talk to trade groups.

I do occasionally talk to the local folks at the FDIC, who is our primary federal regulator, on an occasional basis when the bigger issues hit. And as an example, they called on Monday asking how the brokered CD market was handling the IndyMac situation over the weekend, which I can happily report that there really has been no impact whatsoever in the brokered CD market as a result of that.

The IndyMac situation, which is very, very unfortunate, was handled and is being carried out just as everybody would have expected it to be carried out.

So obviously, you have the big discussions when they're on-site for the three or four weeks that they are each year. Obviously, it has been six, seven months now since they have been here. But we do have an occasional conversation with them directly, just on some of the bigger items such as the brokered CD market.

Steve Covington, Stieven Capital.

I missed part of the early comments, so I apologize if you have already touched on this. But can you disclose what your level of specific reserves are in the allowance versus any type of unallocated or formula-driven reserves?

No, we traditionally haven't provided that. I don't know if it's a big secret. I don't know if we've ever been asked that question before. I don't have that information.

I guess I'm just trying to get a feeling for where you might run or where your formula will drive your reserve (multiple speakers).

Let me touch on that a little bit, and obviously we're in a very dynamic and fluid situation here. A vast, vast -- I can say a vast majority of our loan loss reserve are general allocations and not specific reserves. If I had to just guess, I would say specific reserves are probably in the neighborhood of, say, $6 million, but that is a neighborhood guess as I sit here.

So you would likely see some continued higher than traditionally, certainly, charge-offs from the Company over the next few quarters, although we would expect that, through our review process, that a good percentage, a pretty high percentage of those charge-offs will be the elimination of specific reserves as we move through the process of identifying the credits, setting up the reserves, and obviously coming to some sort of resolution with those credits, whether it be the charge-offs, foreclosures or maybe correcting the situation by improving the overall borrower relationship with that customer, such as additional collateral or those types of things.

(OPERATOR INSTRUCTIONS) John Szabo, Flintridge Capital.

I appreciate the detail that you have provided. Just one question on the competitive environment. You noted that the structure of the loan environment has improved. What do you think it is going to take to get the deposit environment to improve? You mentioned a little bit about that in an answer to the prior question, but what is the potential for that to improve your margins, say, over the next year to 18 months?

This is Chuck. Certainly, we look at that from a positive standpoint. A lot of our deposit growth, especially the demand deposit growth, is going to come from commercial loan relationships. As a commercial bank, obviously, we try to tie that into the loans.

So when we do bring on the loans, and as Mike touched on already, during the second quarter a lot of our loan growth was the C&I. And quite frankly, that is where a lot of the demand deposit growth is going to come from. So just a pickup in loan growth is certainly going to help the local deposit numbers.

As we have seen some of the bigger players kind of step back from the marketplace, that would seem to me -- it is kind of a more recent phenomenon, so we really haven't seen it totally in the marketplace yet, but it would seem to me that if they were to step back from their lending, that their demand for funds for deposits would lessen, and hopefully that would put less pressure on the deposit competitive environment, and therefore we would see a little bit lower rates.

One of the issues we're definitely grappling with with some of the players in our marketplace, with the headlines they have been getting, I think they have kind of had some rather significant, kind of those sign-up runs in the banks, where customers get nervous and start withdrawing some of their funds, especially maybe the uninsured portions. And I think to counter that, we have seen some pretty aggressive CD rates, some CD campaigns in our marketplace, rates that are significantly above the brokered rates that certainly we are not going to match.

We traditionally have always tried to be in the top three of our banks when it comes to deposit pricing, but quite frankly, some of these specials that we're seeing out there are well above what we think is appropriate and in fact are well above brokered CDs.

So I think, kind of to summarize, I am hoping that with some loan growth, we will see some deposit there, and maybe with some of these other banks stepping back a little bit, they won't be so aggressive in trying to raise local deposits. And hopefully that transpires into some lower local deposit rates.

But I think, on an overall basis, the marketplaces that we have been in have traditionally been quite a bit higher than most of the other markets throughout the country. We see that through the brokered CD pricing. So I think that we're always going to stay a little bit above, but hopefully from what we have seen over the last six, 12, even 18 months, hopefully we will see less pressure there.

And then you mentioned, I think, the $500 million roughly of higher-cost funding that is rolling off this year, and then $500 million next year. Is that spread fairly ratably across the calendar, or are there any bigger deposits in a particular time period?

That is a good question. We try to keep a relatively laddered approach. Most of our funds, because of the relative short-term nature of our asset side, are going to mature within 12 months. I would say, if I had to guess right now, I haven't calculated it yet, our average maturity is probably somewhere between eight and nine months.

It just so happens that July this month was actually one of our biggest months ever. We've got about $100 million set to mature this month at a cost of about 5.02%. But on an average basis, going forward over the next 12 months, it probably averages somewhere in the $60 million to $80 million range. Once you get past 12 months, it is kind of more of the $15 million, $20 million range for the next 12 months after that.

Okay. So would it be fair to say, then, that from an interest rate environment or from an interest rate standpoint, you would be okay with the status quo, or would you actually prefer to see rates increase?

I think, selfishly, if we were just to look at it short term, certainly an increase in the prime rate would be very beneficial to us, because not only would we see a continued reduction of the cost of funds, but obviously, we would also see an increase in the asset yield of our loan portfolio.

But that is short-term thinking. Certainly, with the economics struggles, not only just local and regional, but certainly national, obviously an increase in the prime rate would put additional pressures on our borrowers, so that might tip the asset quality scale a little bit.

So it seems to me that we are probably going to sit here with some relatively stable rates with regard to prime and some of the other things for the next couple quarters, but it has been a very, very volatile market, as you know. It seems like minds are changed significantly from day to day or week to week anyway. And so we try to manage the best that we can through that.

Our thought process is that the prime probably doesn't change for the rest of most of this year, anyway, that at least would have [a necessarily] impact on this year. And with that, we expect a stable asset yield, but with the continued reduction of our cost of funds.

Okay. And then you mentioned with regard to asset growth that capital usage would be an issue. How do you feel about your capital situation? And if you wanted to grow that loan portfolio a little bit more aggressively, are there any steps that you could take to accelerate that process?

Yes. This is Mike again. We certainly feel good about our capital situation, obviously. We have always felt very, very important for us to remain in good excess of being well, well capitalized. But we want to make sure that we stay that course through these rough waters here.

From a competitive standpoint and from a marketplace standpoint, yes, there is a lot of volume that we could probably start to bring on, but we want to make sure that we bring it on judiciously. We have no plans of going back to the Mercantile of old, if you will, right now, anyway, of saying, gee, we're going to grow $300 million in a year type of thing.

But there is some opportunity there now where, if we want to, and we're looking at these situations very, very closely, we are really leaning more toward C&I, obviously, than CRE, but to look at some situations and get the proper pricing and the proper deposit mix and bring some on board.

Okay. So is it fair to say that the incremental net interest margin on the new loan growth is higher than the current net interest margin?

Yes. We are very careful to make sure that we look at whatever we bring on to make sure that it is a very profitable situation, whether it be through a combination of net interest income, fee income, ancillary business or all of the above.

I'm sorry if I couldn't find this, but I'm just trying to understand, just in looking at your March Q, the construction and land development. Do we know what percentage of that is residential versus true commercial?

Well, the land development portfolio is about $135 million, with about another $54 million in one-to-four-family residential housing construction. So it's about $189 million as of the end of the quarter.

And so when you say land development, that would be commercial?

That is residential.

That's residential, okay. And of the -- well, are there any other sort of relationships there that maybe aren't on the watchlist, but are things that you are watching carefully?

We tried to throw, starting with the fourth quarter last year, any residential land development deal that wasn't just doing great with a whole lot of belt-and-suspender to it, we tried to throw that on to the watchlist. And I think, just to give you a little bit of color on that, there is, as I said, $135 million in residential land development. That is the total portfolio. About $12 million of that is in nonperforming right now.

So you are almost approaching 10% of that particular slice of the portfolio is already on the nonperforming list. And some of that, as I've mentioned before, is even paying every month, contractually current, but it's residential real estate development, and we just don't like it. So we've shoved it into the nonperforming area. And if we can collect it all and get our interest later, we will be happy. But right now, we are being very conservative in putting it there.

So if you had to look at it from a credit quality standpoint, are you more concerned about that residential loan portfolio versus, say, the commercial business, or do you think we've seen the worst in the residential and now you are kind of --

Yes, I think you would like to say you have seen the worst in the residential. And from the standpoint that during the last two quarters, since we really went through and scrubbed the portfolio in December, the last two quarters have seen very, very little, if any, new residential land development come on to the watchlist.

The biggest issue we have is just, as we have gone through and as every bank is doing right now, you go out and you say, okay, let's -- obviously, we had an appraisal when the loan was made, whether that was two, three years ago or whatever. Now let's get it reappraised. You get these new values in, and they indicate, holy cow, they've taken another 10% or 15%, sometimes 20% hit. And that is what we've really seen as far as the last two quarters in any downgrades in that particular area.

We had one -- the only codicil that we had one relatively large relationship where a person with a very large net worth lost that net worth in a very short period of time and was no longer able to keep the payments up to speed.

Okay. And then, should I assume that most of those loans were written at 75% loan to value?

Yes, they were all conforming loans at the time they were made. But obviously, what has happened out there in the marketplace, they don't look so performing anymore.

Right. And so in terms of the ultimate recovery of those assets, whether it is returning to performance status or liquidating the assets that you need to foreclose, do you really need to see a pickup in residential construction, or do you think that the prices have gotten to a point where maybe some longer-term investor type money is going to come in?

We have seen the last couple of quarters now people who are starting to say, gee, these residential lots that two years ago were selling for $45,000 to $50,000, people are coming in and actually buying them at $20,000 kind of thing. So they are seeing that 50% reduction, and that does seem to be a spot that certain people are coming in and buying them.

And it is not a groundswell. We don't have tons of people coming from around the country to say, let's buy Michigan real estate. But there are people now. We are starting to see some movement. We are starting to get paydowns on some of these deals. They certainly don't come in as quickly as we'd like, where everybody, I think, when these loans were made, were assuming five to 10 lots a month would be sold. Now we may get a couple a quarter, or maybe one a month, if we are lucky two a month. But that is progress, and we are starting to see that happen.

Okay. And then just one last thing. In terms of the residential real estate values, have you seen that sort of stabilize in your geographies?

They have stabilized. They've stabilized at very, very low numbers, but they have stabilized. And I think that is a good sign going forward. We actually are seeing some, in certain markets, and Grand Rapids was one of them, we are actually seeing the number of sales per month going up compared to a year ago.

What is shocking to the market, to people who are selling and to banks and everything, is that the number, the average sale price is significantly down. And I think that is the new paradigm we're going to be operating for a while. I think sellers are finally realizing that if I had a $400,000 house, or at least I thought it was, and it might be appraised and [SCB] might be there, in fact, today it may be a $310,000 house or some such number. But we aren't seeing that total freefall of prices that we were seeing earlier. It's just that what stabilizes is a pretty low number. It is a shocking number, when you think of the history of real estate in the United States.

Right. And those folks that are buying at that shockingly low number, they're not having any problems getting financing?

You know, that is a good question. If you are buying, when I say buying, I'm assuming that those people are getting financing. But there's no question that getting financing is harder than it should be today for people. We have fortunately washed a lot of these brokers out of the market that caused the subprime thing that is causing all the rest of us to suffer through the implications of that.

But yes, clearly, you actually need to show that you have income now, and you need to show that you can manage your credit. And it is almost like it was 20 years ago, and that's okay by us.

Just sort of as an aside, do you think that community banks in general are better positioned to kind of get through this, and that you might see a return to sort of that older-style banking, where your community bank is going to hold your mortgage and they are going to fund your business?

Well, depending on what happens to Freddie and Fannie, we may be having a whole lot more -- and hopefully, Freddie and Fannie will be just fine. They appear to be. But yes, I think a lot of us community banks, really, we have been old-style lenders as far as we like to see income and we like to see verification of collateral and that type of thing.

But the world got real ahead of itself on this real estate market. And even though, again, we were the old-fashioned 80%, for example, on a residential real estate development loan, and we took guarantees and everything, when those values dropped from 100% of what they were selling to 50% and the velocity of sales goes to trickle, it can just stress community banks, regional banks and very large banks all alike, as well as certainly the developers who, most of them end up going out of business and losing their net worth.

Okay. Thanks very much, and good luck.

Ladies and gentlemen, we have no further questions at this time. Mr. Price, I will turn the call back over to you for any additional remarks.

Thank you very much. Thank you all, again, for your interest in the Company. We, again, are disappointed with the loss, but for the first time, as I said earlier, in many quarters, we feel that the margin is poised to show some significant improvement here over the next few quarters. And certainly, the pace of asset quality issues, at least as I look at the end of the quarter and the first few weeks of this quarter, look like they have significantly subsided. We look forward to talking to you at the next quarter.

That does conclude today's conference call. Thank you for your participation. You may disconnect at this time.