Forward-Looking Statements
This report contains forward-looking statements that are based on management's beliefs, assumptions, current expectations, estimates and projections about the financial services industry, the economy, and our company. Words such as "anticipates," "believes," "estimates," "expects," "intends," "is likely," "plans," "projects," "indicates," "strategy," "future," "likely," "may," "should," "will," and variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions ("Future Factors") that are difficult to predict with regard to timing, extent, likelihood and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed or forecasted in such forward-looking statements. We undertake no obligation to update, amend, or clarify forward-looking statements, whether as a result of new information, future events (whether anticipated or unanticipated), or otherwise. Future Factors include, among others, adverse changes in interest rates and interest rate relationships; significant declines in the value of commercial real estate; market volatility; demand for products and services; the degree of competition by traditional and non-traditional competitors; changes in banking regulation or actions by bank regulators; changes in the method of determining Libor, or the replacement of Libor with an alternative reference rate; changes in tax laws; changes in prices, levies, and assessments; the impact of technological advances; risks associated with cyber-attacks on our computer systems; governmental and regulatory policy changes; our participation in the Paycheck Protection Program administered by theSmall Business Administration ; the outcomes of contingencies; trends in customer behavior as well as their ability to repay loans; changes in local real estate values; damage to our reputation resulting from adverse publicity, regulatory actions, litigation, operational failures, the failure to meet client expectations and other facts; changes in the national and local economies, including the significant disruption to financial market and other economic activity caused by the outbreak and continuance of Covid-19; and risk factors described in our annual report on Form 10-K for the year endedDecember 31, 2020 or in this report. These are representative of the Future Factors that could cause a difference between an ultimate actual outcome and a forward-looking statement.
Introduction
The following discussion compares the financial condition ofMercantile Bank Corporation and its consolidated subsidiaries, includingMercantile Bank of Michigan ("our bank") and our bank's subsidiaryMercantile Insurance Center, Inc. ("our insurance company"), atMarch 31, 2021 andDecember 31, 2020 and the results of operations for the three months endedMarch 31, 2021 andMarch 31, 2020 . This discussion should be read in conjunction with the interim consolidated financial statements and footnotes included in this report. Unless the text clearly suggests otherwise, references in this report to "us," "we," "our" or "the company" includeMercantile Bank Corporation and its consolidated subsidiaries referred to above.
Critical Accounting Policies
GAAP is complex and requires us to apply significant judgment to various accounting, reporting and disclosure matters. We must use assumptions and estimates to apply these principles where actual measurements are not possible or practical. This Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our unaudited financial statements included in this report. For a discussion of our significant accounting policies, see Note 1 of the Notes to our Consolidated Financial Statements included in our Form 10-K for the fiscal year endedDecember 31, 2020 (Commission file number 000-26719). Our critical accounting policies are highly dependent upon subjective or complex judgments, assumptions and estimates. Changes in such estimates may have a significant impact on the financial statements, and actual results may differ from those estimates. We have reviewed the application of these policies with the Audit Committee of our Board of Directors.
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-------------------------------------------------------------------------------- Allowance for Loan Losses: The allowance for loan losses ("allowance") is maintained at a level we believe is adequate to absorb probable incurred losses identified and inherent in the loan portfolio. Our evaluation of the adequacy of the allowance is an estimate based on past loan loss experience, the nature and volume of the loan portfolio, information about specific borrower situations and estimated collateral values, guidance from bank regulatory agencies, and assessments of the impact of current and anticipated economic conditions on the loan portfolio. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in our judgment, should be charged-off. Loan losses are charged against the allowance when we believe the uncollectability of a loan is likely. The balance of the allowance represents our best estimate, but significant downturns in circumstances relating to loan quality or economic conditions could result in a requirement for an increased allowance in the future. Likewise, an upturn in loan quality or improved economic conditions may result in a decline in the required allowance in the future. In either instance, unanticipated changes could have a significant impact on the allowance and operating results. Loans made under the Paycheck Protection Program are fully guaranteed by theSmall Business Administration ; therefore, such loans do not have an associated allowance. The allowance is increased through a provision charged to operating expense. Uncollectable loans are charged-off through the allowance. Recoveries of loans previously charged-off are added to the allowance. A loan is considered impaired when it is probable that contractual interest and principal payments will not be collected either for the amounts or by the dates as scheduled in the loan agreement. Impairment is evaluated on an individual loan basis. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan's existing rate or at the fair value of collateral if repayment is expected solely from the collateral. The timing of obtaining outside appraisals varies, generally depending on the nature and complexity of the property being evaluated, general breadth of activity within the marketplace and the age of the most recent appraisal. For collateral dependent impaired loans, in most cases we obtain and use the "as is" value as indicated in the appraisal report, adjusting for any expected selling costs. In certain circumstances, we may internally update outside appraisals based on recent information impacting a particular or similar property, or due to identifiable trends (e.g., recent sales of similar properties) within our markets. The expected future cash flows exclude potential cash flows from certain guarantors. To the extent these guarantors provide repayments, a recovery would be recorded upon receipt. Loans are evaluated for impairment when payments are delayed, typically 30 days or more, or when serious deficiencies are identified within the credit relationship. Our policy for recognizing income on impaired loans is to accrue interest unless a loan is placed on nonaccrual status. We put loans into nonaccrual status when the full collection of principal and interest is not expected. Financial institutions were not required to comply with the Current Expected Credit Loss ("CECL") methodology requirements from the enactment date of the Coronavirus Aid, Relief and Economic Security Act ("CARES Act") until the earlier of the end of the President's declaration of a National Emergency orDecember 31, 2020 . The Consolidated Appropriations Act, 2021, that was enacted inDecember 2020 , provided for an extension of the required CECL adoption date toJanuary 1, 2022 , which is the date we expect to adopt. An economic forecast is a key component of the CECL methodology. As we continue to experience an unprecedented economic environment whereby a sizable portion of the economy has been significantly impacted by government-imposed activity limitations and similar reactions by businesses and individuals, substantial government stimulus has been provided to businesses, individuals and state and local governments and financial institutions have offered businesses and individuals payment relief options, economic forecasts are regularly revised with no economic forecast consensus. Given the high degree of uncertainty surrounding economic forecasting, we have elected to postpone the adoption of CECL, and will continue to use our incurred loan loss reserve model as permitted. -------------------------------------------------------------------------------- 48
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-------------------------------------------------------------------------------- Income Tax Accounting: Current income tax assets and liabilities are established for the amount of taxes payable or refundable for the current year. In the preparation of income tax returns, tax positions are taken based on interpretation of federal and state income tax laws for which the outcome may be uncertain. We periodically review and evaluate the status of our tax positions and make adjustments as necessary. Deferred income tax assets and liabilities are also established for the future tax consequences of events that have been recognized in our financial statements or tax returns. A deferred income tax asset or liability is recognized for the estimated future tax effects attributable to temporary differences that can be carried forward (used) in future years. The valuation of our net deferred income tax asset is considered critical as it requires us to make estimates based on provisions of the enacted tax laws. The assessment of the realizability of the net deferred income tax asset involves the use of estimates, assumptions, interpretations and judgments concerning accounting pronouncements, federal and state tax codes and the extent of future taxable income. There can be no assurance that future events, such as court decisions, positions of federal and state tax authorities, and the extent of future taxable income will not differ from our current assessment, the impact of which could be significant to the consolidated results of operations and reported earnings. Accounting guidance requires that we assess whether a valuation allowance should be established against our deferred tax assets based on the consideration of all available evidence using a "more likely than not" standard. In making such judgments, we consider both positive and negative evidence and analyze changes in near-term market conditions as well as other factors which may impact future operating results. Significant weight is given to evidence that can be objectively verified. Securities and Other Financial Instruments: Securities available for sale consist of bonds and notes which might be sold prior to maturity due to changes in interest rates, prepayment risks, yield and availability of alternative investments, liquidity needs or other factors. Securities classified as available for sale are reported at their fair value. Declines in the fair value of securities below their cost that are other-than-temporary are reflected as realized losses. In estimating other-than-temporary losses, management considers: (1) the length of time and extent that fair value has been less than carrying value? (2) the financial condition and near term prospects of the issuer? and (3) the Company's ability and intent to hold the security for a period of time sufficient to allow for any anticipated recovery in fair value. Fair values for securities available for sale are obtained from outside sources and applied to individual securities within the portfolio. The difference between the amortized cost and the current fair value of securities is recorded as a valuation adjustment and reported in other comprehensive income. Mortgage Servicing Rights: Mortgage servicing rights are recognized as assets based on the allocated fair value of retained servicing rights on loans sold. Servicing rights are carried at the lower of amortized cost or fair value and are expensed in proportion to, and over the period of, estimated net servicing income. We utilize a discounted cash flow model to determine the value of our servicing rights. The valuation model utilizes mortgage prepayment speeds, the remaining life of the mortgage pool, delinquency rates, our cost to service loans, and other factors to determine the cash flow that we will receive from servicing each grouping of loans. These cash flows are then discounted based on current interest rate assumptions to arrive at the fair value of the right to service those loans. Impairment is evaluated quarterly based on the fair value of the servicing rights, using groupings of the underlying loans classified by interest rates. Any impairment of a grouping is reported as a valuation allowance.Goodwill : GAAP requires us to determine the fair value of all of the assets and liabilities of an acquired entity, and record their fair value on the date of acquisition. We employ a variety of means in determination of the fair value, including the use of discounted cash flow analysis, market comparisons, and projected future revenue streams. For certain items that we believe we have the appropriate expertise to determine the fair value, we may choose to use our own calculation of the value. In other cases, where the value is not easily determined, we consult with outside parties to determine the fair value of the asset or liability. Once valuations have been adjusted, the net difference between the price paid for the acquired company and the value of its balance sheet is recorded as goodwill.Goodwill results from business acquisitions and represents the excess of the purchase price over the fair value of acquired tangible assets and liabilities and identifiable intangible assets.Goodwill is assessed at least annually for impairment and any such impairment is recognized in the period identified. A more frequent assessment is performed if conditions in the market place or changes in the company's organizational structure occur. -------------------------------------------------------------------------------- 49
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Coronavirus Pandemic
TheU.S. economy deteriorated rapidly during the latter part of the first quarter and into the second quarter of 2020 due to the ongoing pandemic of coronavirus disease 2019 ("Covid-19") caused by severe acute respiratory syndrome coronavirus 2 (the "Coronavirus Pandemic"). While the economic fallout has stabilized somewhat and the adult population inthe United States is in the process of being vaccinated, there remains a significant amount of stress and uncertainty across national and global economies. This uncertainty is heightened as certain geographic areas continue to experience surges in Covid-19 cases and governments at all levels continue to react to changes in circumstances. The Coronavirus Pandemic is a highly unusual, unprecedented and evolving public health and economic crisis and may have a material negative impact on our financial condition and results of operations. We continue to occupy an asset-sensitive position, whereby interest rate environments characterized by numerous and/or high magnitude interest rate reductions have a negative impact on our net interest income and net income. Additionally, the consequences of the unprecedented economic impact of the Coronavirus Pandemic may produce declining asset quality, reflected by a higher level of loan delinquencies and loan charge-offs, as well as downgrades of commercial lending relationships, which may necessitate additional provisions for our allowance and reduced net income.
The following section summarizes the primary measures that directly impact us and our customers.
? Paycheck Protection Program The Paycheck Protection Program ("PPP") reflects a substantial expansion of theSmall Business Administration's 100% guaranteed 7(a) loan program. The CARES Act authorized up to$350 billion in loans to businesses with fewer than 500 employees, including non-profit organizations, tribal business concerns, self-employed and individual contractors. The PPP provides 100% guaranteed loans to cover specific operating costs. PPP loans are eligible to be forgiven based upon certain criteria. In general, the amount of the loan that is forgivable is the sum of the payroll costs, interest payments on mortgages, rent and utilities incurred or paid by the business during a prescribed period beginning on the loan origination date. Any remaining balance after forgiveness is maintained at the 100% guarantee for the duration of the loan. The interest rate on the loan is fixed at 1.00%, with the financial institution receiving a loan origination fee paid by theSmall Business Administration . The loan origination fees, net of the direct origination costs, are accreted into interest income on loans using the level yield methodology. The program ended onAugust 8, 2020 . We originated approximately 2,200 loans aggregating$553 million . As ofMarch 31, 2021 , we recorded forgiveness transactions on approximately 1,600 loans aggregating$302 million . The Consolidated Appropriations Act, 2021 authorized an additional$284 billion in second draw PPP loans ("round 2 PPP loans"). The program is scheduled to end onMay 31, 2021 . ThroughMarch 31, 2021 , we originated approximately 1,100 loans aggregating$203 million .
A PPP loan is assigned a risk weight of 0% under the risk-based capital rules of the federal banking agencies.
? Individual Economic Impact Payments The Internal Revenue Service has made three rounds of Individual Economic Impact Payments via direct deposit or mailed checks. In general, and subject to adjusted gross income limitations, qualifying individuals have received payments of$1,200 inApril 2020 ,$600 inJanuary 2021 and$1,400 inMarch 2021 . ? Troubled Debt Restructuring Relief FromMarch 1, 2020 through 60 days after the end of the National Emergency (orDecember 31, 2020 if earlier), a financial institution may elect to suspend GAAP principles and regulatory determinations with respect to loan modifications related to Covid-19 that would otherwise be categorized as troubled debt restructurings. Banking agencies must defer to the financial institution's election. We elected to suspend GAAP principles and regulatory determinations as permitted. The Consolidated Appropriations Act, 2021 extended the suspension date toJanuary 1, 2022 .
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? Current Expected Credit Loss Methodology Delay
Financial institutions are not required to comply with the CECL methodology requirements from the enactment date of the CARES Act until the earlier of the end of the National Emergency orDecember 31, 2020 . We elected to postpone CECL adoption as permitted. The Consolidated Appropriations Act, 2021 extended the adoption deferral date toJanuary 1, 2022 . In earlyApril 2020 , in response to the early stages of the Coronavirus Pandemic and its pervasive impact across the economy and financial markets, we developed internal programs of loan payment deferments for commercial and retail borrowers. For commercial borrowers, we offered 90-day (three payments) interest only amendments as well as 90-day (three payments) principal and interest payment deferments. Under the latter program, borrowers were extended a 12-month single payment note at 0% interest in an amount equal to three payments, with loan proceeds used to make the scheduled payments. The single payment notes receive a loan grade equal to the loan grade of each respective borrowing relationship. Certain of our commercial loan borrowers subsequently requested and received an additional 90-day (three payments) interest only amendment or 90-day (three payments) principal and interest payment deferment. Under the latter program, the amount equal to the three payments was added to the original deferment note which has nine months remaining to maturity; however, the original 0% interest rate is modified to equal the rate associated with each borrower's traditional lending relationship with us for the remainder of the term. At the peak of activity in mid-2020, nearly 750 borrowers with loan balances aggregating$719 million were participating in the commercial loan deferment program. As ofMarch 31, 2021 , only two borrowers with loan balances aggregating$1.8 million remained in the commercial loan deferment program. For retail borrowers, we offered 90-day (three payments) principal and interest payment deferments, with deferred amounts added to the end of the loan. As ofJune 30, 2020 , we had processed 260 principal and interest payment deferments with loan balances totaling$23.8 million . These payment deferral transactions largely applied to the borrowers' April, May and June of 2020 loan payments. As ofMarch 31, 2021 , only ten borrowers with loan balances aggregating$0.8 million remained in the retail loan payment deferment program.
First Quarter 2021 Financial Overview
We reported net income of$14.2 million , or$0.87 per diluted share, for the first quarter of 2021, compared with net income of$10.7 million , or$0.65 per diluted share, during the first quarter of 2020. The overall quality of our loan portfolio remains strong, with nonperforming loans equaling only 0.08% of total loans as ofMarch 31, 2021 . Accruing loans past due 30 to 89 days remain very low. Gross loan charge-offs totaled$0.1 million during the first quarter of 2021, while recoveries of prior period loan charge-offs totaled$0.5 million , providing for net loan recoveries of$0.4 million , or 0.05% of average total loans on an annualized basis. We continue our collection efforts on charged-off loans and expect to record recoveries in future periods; however, given the nature of these efforts, it is not practical to forecast the dollar amount and timing of the recoveries. Provision expense during the first quarter of 2021 totaled$0.3 million , which combined with net loan recoveries provided for a$0.7 million increase in the balance of the loan loss reserve. Commercial loans increased$173 million during the first three months of 2021, reflecting the combined net growth of core commercial loans and net activity under the PPP. Core commercial loans increased$83.7 million , or about 14% on an annualized basis, during the first three months of 2021. Commercial and industrial loans increased$49.5 million , non-owner occupied commercial real estate ("CRE") loans grew$14.9 million , owner occupied CRE loans were up$14.4 million , vacant land, land development and residential construction loans increased$3.7 million and multi-family and residential rental property loans grew$1.2 million . As a percent of total commercial loans, commercial and industrial loans (excluding PPP loans) and owner occupied CRE loans combined equaled 54.7% as ofMarch 31, 2021 , compared to 53.9% atDecember 31, 2020 . Origination of second round PPP loans during the first quarter totaled$203 million , while PPP loan forgiveness payments from theSmall Business Administration of first round PPP loans totaled$113 million , providing for net increase in PPP loans of$89.6 million . -------------------------------------------------------------------------------- 51
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-------------------------------------------------------------------------------- Total deposits increased$233 million during the first three months of 2021, totaling$3.64 billion atMarch 31, 2021 . Local deposits increased$249 million , while out-of-area deposits decreased$16.0 million . Noninterest-bearing deposits increased$172 million during the first three months of 2021, while interest-bearing checking accounts and money market deposit accounts increased$21.4 million and$62.0 million , respectively. The increases in these transactional deposit products largely reflect federal government stimulus, especially the PPP, as well as lower business investing and spending. Savings deposits were up$33.3 million during the first quarter of 2021, primarily reflecting the impact of federal government stimulus programs and lower consumer investing and spending. Local time deposits declined$39.4 during the first three months of 2021, in large part reflecting the maturity of certain time deposits that were not renewed during the quarter as we did not aggressively seek to renew these time deposits which were opened as part of a special time deposit campaign that primarily ran during the latter half of the first quarter of 2019. The reduction of out-of-area deposits during the first three months of 2021 reflects maturities not replaced as the funds were no longer needed. Interest-earning balances, primarily consisting of excess funds deposited at theFederal Reserve Bank of Chicago and a correspondent bank, are used to manage daily liquidity needs and interest rate sensitivity. During the first three months of 2021, the average balance of these funds equaled$592 million , or 13.7% of average earning assets, compared to$357 million , or 9.2% of average earning assets, during 2020, and a more typical$115 million , or 3.4% of average earning assets, during 2019. The elevated level during 2020 and into the first quarter of 2021, in large part reflecting increased local deposit balances, has had a significant negative impact on our net interest margin. Net interest income totaled$29.5 million during the first quarter of 2021, compared to$30.3 million during the same time period in 2020. The decline reflects a lower net interest margin primarily resulting from theFederal Open Market Committee's ("FOMC") decision to lower the targeted federal funds rate by a total of 150 basis points at the onset of the Coronavirus Pandemic in early March of 2020 and substantial excess liquidity, which more than offset the positive impact of an increase in average earning assets. Noninterest income totaled$13.5 million during the first quarter of 2021, up approximately 106% from the first quarter in 2020. The improved level mainly resulted from increased mortgage banking income stemming from a substantial upturn in refinance activity driven by a lower interest rate environment, an increase in home purchase activity and the ongoing success of strategic initiatives that have been implemented to gain market share. Fee income generated from an interest rate swap program that was initiated within our commercial lending function during the fourth quarter of 2020 also contributed to the increased level of noninterest income during the first three months of 2021. Noninterest expense totaled$25.1 million during the first quarter of 2021, compared to$22.9 million during the same time period in 2020. The increased level of noninterest expense primarily reflects increased employee compensation costs, mainly depicting higher mortgage lender commissions and annual merit employee pay increases, higher employee health insurance costs and a bonus accrual. The higher level of mortgage lending commissions and associated incentives primarily reflects the significant increase in residential mortgage loan originations during the first quarter of 2021, which were up nearly 85% compared to the respective 2020 period. We did not accrue monies for the bonus programs during the first quarter of 2020 due to the onset of the Coronavirus Pandemic. Valuation write-downs of two former branch facilities totaled$0.5 million during the first three months of 2021.
Financial Condition
Our total assets increased$273 million during the first three months of 2021, and totaled$4.71 billion as ofMarch 31, 2021 . Total loans increased$171 million , securities available for sale grew$46.9 million and cash and cash equivalents increased$26.3 million . Total deposits increased$233 million and sweep accounts grew$22.9 million during the first three months of 2021. -------------------------------------------------------------------------------- 52
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-------------------------------------------------------------------------------- Commercial loans increased$173 million during the first three months of 2021, and atMarch 31, 2021 totaled$2.97 billion , or 88.2% of the loan portfolio. As ofDecember 31, 2020 , the commercial loan portfolio comprised 87.5% of total loans. The increase in commercial loans during the first quarter reflects combined net growth of core commercial loans of$83.7 million and net activity under PPP. Origination of second round PPP loans during the first quarter totaled$203 million , while PPP loan forgiveness payments from theSmall Business Administration of first round PPP loans totaled$113 million , providing for a net increase in PPP loans of$89.6 million . Core commercial loans increased$83.7 million , or about 14% on an annualized basis, during the first three months of 2021. Commercial and industrial loans increased$49.5 million , non-owner occupied CRE loans grew$14.9 million , owner occupied CRE loans were up$14.4 million , vacant land, land development and residential construction loans increased$3.7 million and multi-family and residential rental property loans grew$1.2 million . As a percent of total commercial loans, commercial and industrial loans (excluding PPP loans) and owner occupied CRE loans combined equaled 54.7% as ofMarch 31, 2021 , compared to 53.9% atDecember 31, 2020 . As ofMarch 31, 2021 , availability on existing construction and development loans totaled$135 million , with most of those funds expected to be drawn over the next 12 to 18 months. Our current pipeline reports indicate continued strong commercial loan funding opportunities in future periods, including approximately$177 million in new lending commitments, a majority of which we expect to be accepted and funded over the next 12 to 18 months. Our commercial lenders also report ongoing additional opportunities they are currently discussing with existing and potentially new borrowers. We remain committed to prudent underwriting standards that provide for an appropriate yield and risk relationship, as well as concentration limits we have established within our commercial loan portfolio. Usage of existing commercial lines of credit remained relatively steady during the first quarter of 2021, similar to levels during the last six months of 2020. Residential mortgage loans decreased less than$0.1 million during the first quarter of 2021, totaling$338 million , or 10.0% of total loans, as ofMarch 31, 2021 . Activity within the residential mortgage function was very active, primarily reflecting ongoing significant refinance transactions spurred by low residential mortgage loan interest rates, ongoing strength in home purchase activity, and the continuing success of strategic initiatives that have been implemented over the past several years to gain market share and increase production. Residential mortgage loan originations totaled$245 million during the first three months of 2021, an almost 85% increase over the$133 million originated during the same time period in 2020. Refinance mortgage loans originated comprised about 67% of the total mortgage loans originated during the first quarter of 2021, compared to almost 65% during the first quarter of 2020. Residential mortgage loans originated for sale, generally consisting of longer-term fixed rate residential mortgage loans, totaled$196 million during the first quarter of 2021, or almost 80% of the total residential mortgage loans originated. Residential mortgage loans originated not sold are generally comprised of adjustable rate residential mortgage loans. We remain pleased with the results of our strategic initiatives associated with the growth of our residential mortgage banking operation over the past few years, and remain optimistic that origination volumes will remain solid in future periods. Other consumer-related loans declined$2.3 million during the first quarter of 2021, and atMarch 31, 2021 totaled$59.3 million , or 1.8% of total loans. Other consumer-related loans comprised 1.9% of total loans as ofDecember 31, 2020 . We expect this loan portfolio segment to decline in future periods as scheduled principal payments exceed origination volumes. -------------------------------------------------------------------------------- 53
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-------------------------------------------------------------------------------- The following table summarizes our loan portfolio over the past twelve months: 3/31/21 12/31/20 9/30/20 6/30/20 3/31/20 Commercial: Commercial & Industrial *$ 1,284,507,000 $ 1,145,423,000
58,738,000 55,055,000
50,941,000 52,984,000 62,908,000 Owner Occupied Commercial RE
544,342,000 529,953,000
549,364,000 567,621,000 579,229,000 Non-Owner Occupied Commercial RE
932,334,000 917,436,000
878,897,000 841,145,000 823,366,000 Multi-Family & Residential Rental 147,294,000 146,095,000
137,740,000 132,047,000 133,148,000 Total Commercial 2,967,215,000 2,793,962,000 2,938,361,000 2,901,252,000 2,472,330,000 Retail: 1-4 Family Mortgages 337,844,000 337,888,000
348,460,000 367,061,000 356,338,000 Home Equity & Other Consumer Loans 59,311,000 61,620,000
63,723,000 64,743,000 72,875,000 Total Retail 397,155,000 399,508,000 412,183,000 431,804,000 429,213,000 Total$ 3,364,370,000 $ 3,193,470,000 $ 3,350,544,000 $ 3,333,056,000 $ 2,901,543,000 (*) Includes$455 million ,$365 million ,$555 million , and$549 million in loans originated under thePaycheck Protection Program forMarch 31, 2021 ,December 31, 2020 ,September 30, 2020 , andJune 30, 2020 , respectively. Our credit policies establish guidelines to manage credit risk and asset quality. These guidelines include loan review and early identification of problem loans to provide effective loan portfolio administration. The credit policies and procedures are meant to minimize the risk and uncertainties inherent in lending. In following these policies and procedures, we must rely on estimates, appraisals and evaluations of loans and the possibility that changes in these could occur quickly because of changing economic conditions. Identified problem loans, which exhibit characteristics (financial or otherwise) that could cause the loans to become nonperforming or require restructuring in the future, are included on an internal watch list. Senior management and the Board of Directors review this list regularly. Market value estimates of collateral on impaired loans, as well as on foreclosed and repossessed assets, are reviewed periodically. We also have a process in place to monitor whether value estimates at each quarter-end are reflective of current market conditions. Our credit policies establish criteria for obtaining appraisals and determining internal value estimates. We may also adjust outside and internal valuations based on identifiable trends within our markets, such as recent sales of similar properties or assets, listing prices and offers received. In addition, we may discount certain appraised and internal value estimates to address distressed market conditions. Nonperforming assets, comprised of nonaccrual loans, loans past due 90 days or more and accruing interest and foreclosed properties, totaled$3.2 million (0.1% of total assets) as ofMarch 31, 2021 , compared to$4.1 million (0.1% of total assets) as ofDecember 31, 2020 . -------------------------------------------------------------------------------- 54
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-------------------------------------------------------------------------------- The following tables provide a breakdown of nonperforming assets by collateral type: NONPERFORMING LOANS 3/31/21 12/31/20 9/30/20 6/30/20 3/31/20
Residential Real Estate : Land Development$ 34,000 $ 35,000 $ 36,000 $ 36,000 $ 37,000 Construction 0 0 198,000 198,000 283,000 Owner Occupied / Rental 2,294,000 2,519,000 2,399,000 2,552,000 2,651,000 2,328,000 2,554,000 2,633,000 2,786,000 2,971,000Commercial Real Estate : Land Development 0 0 0 0 43,000 Construction 0 0 0 0 0 Owner Occupied 283,000 619,000 1,262,000 275,000 287,000 Non-Owner Occupied 0 22,000 23,000 25,000 0 283,000 641,000 1,285,000 300,000 330,000 Non-Real Estate: Commercial Assets 169,000 172,000 198,000 98,000 156,000 Consumer Assets 13,000 17,000 25,000 28,000 12,000 182,000 189,000 223,000 126,000 168,000 Total$ 2,793,000 $ 3,384,000 $ 4,141,000 $ 3,212,000 $ 3,469,000
OTHER REAL ESTATE OWNED & REPOSSESSED ASSETS
3/31/21 12/31/20 9/30/20 6/30/20 3/31/20Residential Real Estate : Land Development$ 0 $ 0 $ 0 $ 0 $ 0 Construction 0 0 0 0 0 Owner Occupied / Rental 11,000 88,000 198,000 198,000 271,000 11,000 88,000 198,000 198,000 271,000Commercial Real Estate : Land Development 0 0 0 0 0 Construction 0 0 0 0 0 Owner Occupied 363,000 613,000 314,000 0 0 Non-Owner Occupied 0 0 0 0 0 363,000 613,000 314,000 0 0 Non-Real Estate: Commercial Assets 0 0 0 0 0 Consumer Assets 0 0 0 0 0 0 0 0 0 0 Total$ 374,000 $ 701,000 $ 512,000 $ 198,000 $ 271,000
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The following tables provide a reconciliation of nonperforming assets:
NONPERFORMING LOANS RECONCILIATION
1st Qtr 4th Qtr 3rd Qtr 2nd Qtr 1st Qtr 2021 2020 2020 2020 2020 Beginning balance$ 3,384,000 $ 4,141,000 $ 3,212,000 $ 3,469,000 $ 2,284,000 Additions, net of transfers to ORE 116,000 538,000 1,301,000 220,000 1,302,000 Returns to performing status (115,000 ) 0 (72,000 ) (26,000 ) (7,000 ) Principal payments (559,000 ) (1,064,000 ) (249,000 ) (278,000 ) (110,000 ) Loan charge-offs (33,000 ) (231,000 ) (51,000 ) (173,000 ) 0 Total$ 2,793,000 $ 3,384,000 $ 4,141,000 $ 3,212,000 $ 3,469,000
OTHER REAL ESTATE OWNED & REPOSSESSED ASSETS RECONCILIATION
1st Qtr 4th Qtr 3rd Qtr 2nd Qtr 1st Qtr 2021 2020 2020 2020 2020
Beginning balance
0 434,000 314,000 0 11,000 Sale proceeds (77,000 ) (245,000 ) 0 (49,000 ) (192,000 ) Valuation write-downs (250,000 ) 0 0 (24,000 ) 0 Total$ 374,000 $ 701,000 $ 512,000 $ 198,000 $ 271,000 During the first quarter of 2021, loan charge-offs totaled$0.1 million while recoveries of prior period loan charge-offs equaled$0.5 million , providing for net loan recoveries of$0.4 million , or an annualized 0.05% of average total loans. We continue our collection efforts on charged-off loans and expect to record recoveries in future periods; however, given the nature of these efforts, it is not practical to forecast the dollar amount and timing of the recoveries. The allowance equaled$38.7 million , or 1.15% of total loans (1.33% of total loans excluding PPP loans), and 1,385% of nonperforming loans as ofMarch 31, 2021 . In each accounting period, we adjust the allowance to the amount we believe is necessary to maintain the allowance at an adequate level. Through the loan review and credit departments, we establish portions of the allowance based on specifically identifiable problem loans. The evaluation of the allowance is further based on, but not limited to, consideration of the internally prepared allowance analysis, loan loss migration analysis, composition of the loan portfolio, third party analysis of the loan administration processes and portfolio, and general economic conditions. Financial institutions were not required to comply with the CECL methodology requirements from the enactment date of the CARES Act until the earlier of the end of the President's declaration of a National Emergency orDecember 31, 2020 . The Consolidated Appropriations Act, 2021, that was enacted inDecember 2020 , provided for an extension of the required CECL adoption date toJanuary 1, 2022 , which is the date we plan to adopt. An economic forecast is a key component of the CECL methodology. As we continue to experience an unprecedented economic environment whereby a sizable portion of the economy has been significantly impacted by government-imposed activity limitations and similar reactions by businesses and individuals, substantial government stimulus has been provided to businesses, individuals and state and local governments and financial institutions have offered businesses and individuals payment relief options, economic forecasts are regularly revised with no economic forecast consensus. Given the high degree of uncertainty surrounding economic forecasting, we have elected to postpone the adoption of CECL, and will continue to use our incurred loan loss reserve model as permitted. -------------------------------------------------------------------------------- 56
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-------------------------------------------------------------------------------- The allowance analysis applies reserve allocation factors to non-impaired outstanding loan balances, the result of which is combined with specific reserves to calculate an overall allowance dollar amount. For non-impaired commercial loans, reserve allocation factors are based on the loan ratings as determined by our standardized grade paradigms and by loan purpose. Our commercial loan portfolio is segregated into five classes: 1) commercial and industrial loans; 2) vacant land, land development and residential construction loans; 3) owner occupied real estate loans; 4) non-owner occupied real estate loans; and 5) multi-family and residential rental property loans. The reserve allocation factors are primarily based on the historical trends of net loan charge-offs through a migration analysis whereby net loan losses are tracked via assigned grades over various time periods, with adjustments made for environmental factors reflecting the current status of, or recent changes in, items such as: lending policies and procedures; economic conditions; nature and volume of the loan portfolio; experience, ability and depth of management and lending staff; volume and severity of past due, nonaccrual and adversely classified loans; effectiveness of the loan review program; value of underlying collateral; loan concentrations; and other external factors such as competition and regulatory environment. We established a Covid-19 reserve allocation factor to address the Coronavirus Pandemic and its potential impact on the collectability of the loan portfolio during the second quarter of 2020. The creation of this factor reflected our belief that the traditional nine environmental factors did not sufficiently capture and address the unique circumstances, challenges and uncertainties associated with the Coronavirus Pandemic, which include unprecedented federal government stimulus and interventions, statewide mandatory closures on nonessential businesses and periodic changes to such, and our ability to provide payment deferral programs to commercial and retail borrowers without the interjection of troubled debt restructuring accounting rules. We review a myriad of items assessing this new environmental factor, including virus infection rates, vaccine inoculation trends, economic outlooks, employment data, business closures, foreclosures, payment deferments and government-sponsored stimulus programs.
No changes were made to the environmental factor ratings during the first quarter of 2021.
Adjustments for specific lending relationships, particularly impaired loans, are made on a case-by-case basis. Non-impaired retail loan reserve allocations are determined in a similar fashion as those for non-impaired commercial loans, except that retail loans are segmented by type of credit and not a grading system. We regularly review the allowance analysis and make needed adjustments based upon identifiable trends and experience. A migration analysis is completed quarterly to assist us in determining appropriate reserve allocation factors for non-impaired commercial loans. Our migration analysis takes into account various time periods, with most weight placed on the time frame fromDecember 31, 2010 throughMarch 31, 2021 . We believe this time period represents an appropriate range of economic conditions, and that it provides for an appropriate basis in determining reserve allocation factors given current economic conditions and the general consensus of economic conditions in the near future. We are actively monitoring our loan portfolio and assessing reserve allocation factors in light of the Coronavirus Pandemic and its impact on theU.S. economic environment and our customers in particular. Although the migration analysis provides a historical accounting of our net loan losses, it is not able to fully account for environmental factors that will also very likely impact the collectability of our commercial loans as of any quarter-end date. Therefore, we incorporate the environmental factors as adjustments to the historical data. Environmental factors include both internal and external items. We believe the most significant internal environmental factor is our credit culture and the relative aggressiveness in assigning and revising commercial loan risk ratings, with the most significant external environmental factor being the assessment of the current economic environment and the resulting implications on our commercial loan portfolio. The primary risk elements with respect to commercial loans are the financial condition of the borrower, the sufficiency of collateral, and timeliness of scheduled payments. We have a policy of requesting and reviewing periodic financial statements from commercial loan customers, and we have a disciplined and formalized review of the existence of collateral and its value. The primary risk element with respect to each residential real estate loan and consumer loan is the timeliness of scheduled payments. We have a reporting system that monitors past due loans and have adopted policies to pursue creditors' rights in order to preserve our collateral position. -------------------------------------------------------------------------------- 57 --------------------------------------------------------------------------------
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-------------------------------------------------------------------------------- As ofMarch 31, 2021 , the allowance was comprised of$38.2 million in general reserves relating to non-impaired loans and$0.5 million in specific reserves on other loans, primarily accruing loans designated as troubled debt restructurings. There were no specific reserve allocations relating to nonaccrual loans. Troubled debt restructurings totaled$20.0 million atMarch 31, 2021 , consisting of$0.4 million that are on nonaccrual status and$19.6 million that are on accrual status. The latter, while considered and accounted for as impaired loans in accordance with accounting guidelines, are not included in our nonperforming loan totals. Impaired loans with an aggregate carrying value of$0.9 million as ofMarch 31, 2021 had been subject to previous partial charge-offs aggregating$1.0 million . Those partial charge-offs were primarily recorded during the time period of 2010 through 2020, averaging approximately$0.1 million per year. As ofMarch 31, 2021 , there were no specific reserves allocated to impaired loans that had been subject to a previous partial charge-off. The following table provides a breakdown of our loans categorized as troubled debt restructurings: 3/31/21 12/31/20 9/30/20 6/30/20 3/31/20 Performing$ 19,606,000 $ 23,133,000 $ 11,522,000 $ 16,018,000 $ 17,975,000 Nonperforming 431,000 510,000 1,113,000 521,000 466,000 Total$ 20,037,000 $ 23,643,000 $ 12,635,000 $ 16,539,000 $ 18,441,000 Although we believe the allowance is adequate to absorb loan losses in our originated loan portfolio as they arise, there can be no assurance, especially given the current uncertainties related to the Coronavirus Pandemic and its impact on theU.S. economic environment, that we will not sustain loan losses in any given period that could be substantial in relation to, or greater than, the size of the allowance. Securities available for sale increased$46.9 million during the first three months of 2021, totaling$434 million as ofMarch 31, 2021 . Purchases ofU.S. Government agency bonds totaled$58.9 million during the first quarter of 2021, in part reflecting the reinvestment of the proceeds from calledU.S. Government agency bonds that totaled$27.4 million during the quarter. Purchases ofU.S. Government agency guaranteed mortgage-backed securities totaled$14.4 million during the first three months of 2021, primarily reflecting investments in CRA-qualified securities and to a lesser degree the reinvestment of$3.0 million from principal paydowns onU.S. Government agency guaranteed mortgage-backed securities. Purchases of municipal bonds totaled$14.1 million during the first quarter of 2021; proceeds from matured municipal bonds totaled$0.6 million . AtMarch 31, 2021 , the portfolio was primarily comprised ofU.S. Government agency bonds (62%), municipal bonds (30%) andU.S. Government agency guaranteed mortgage-backed securities (8%). All of our securities are currently designated as available for sale, and are therefore stated at fair value. The fair value of securities designated as available for sale atMarch 31, 2021 totaled$434 million , including a net unrealized loss of$2.2 million . We maintain the securities portfolio at levels to provide adequate pledging and secondary liquidity for our daily operations. In addition, the securities portfolio serves a primary interest rate risk management function. We expect purchases during the remainder of 2021 to generally consist ofU.S. Government agency bonds and municipal bonds, with the securities portfolio maintained at about 10% of total assets. FHLBI stock totaled$18.0 million as ofMarch 31, 2021 , unchanged from the balance atDecember 31, 2020 . Our investment in FHLBI stock is necessary to engage in their advance and other financing programs. We have regularly received quarterly cash dividends, and we expect a cash dividend will continue to be paid in future quarterly periods. Market values on ourU.S. Government agency bonds, mortgage-backed securities issued or guaranteed byU.S. Government agencies and municipal bonds are generally determined on a monthly basis with the assistance of a third party vendor. Evaluated pricing models that vary by type of security and incorporate available market data are utilized. Standard inputs include issuer and type of security, benchmark yields, reported trades, broker/dealer quotes and issuer spreads. The market value of certain non-rated securities issued by relatively small municipalities generally located within our markets is estimated at carrying value. We believe our valuation methodology provides for a reasonable estimation of market value, and that it is consistent with the requirements of accounting guidelines.
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-------------------------------------------------------------------------------- Interest-earning balances, primarily consisting of excess funds deposited at theFederal Reserve Bank of Chicago and a correspondent bank, are used to manage daily liquidity needs and interest rate sensitivity. During the first three months of 2021, the average balance of these funds equaled$592 million , or 13.7% of average earning assets, compared to$357 million , or 9.2% of average earning assets, during 2020, and a more typical$115 million , or 3.4% of average earning assets, during 2019. The elevated level during 2020 and into the first quarter of 2021 reflects increased local deposit balances, primarily a product of federal government stimulus programs as well as lower business and individual investing and spending. We anticipate the level of interest-earning deposit balances to remain elevated throughout 2021 given the conditions associated with the Coronavirus Pandemic. Net premises and equipment equaled$55.4 million atMarch 31, 2021 , representing a decrease of$3.6 million during the first three months of 2021. The decline was primarily attributable to the transfer of$3.5 million associated with two branch locations from net premises and equipment to assets held for sale, combined with depreciation expense of$1.4 million . Leasehold improvements and equipment purchases during the first quarter of 2021 aggregated$1.3 million . Foreclosed and repossessed assets equaled$0.4 million as ofMarch 31, 2021 , down$0.3 million from year-end 2020. Total deposits increased$233 million during the first three months of 2021, totaling$3.64 billion atMarch 31, 2021 . Local deposits increased$249 million , while out-of-area deposits decreased$16.0 million during the first three months of 2021. As a percent of total deposits, out-of-area deposits equaled 0.8% as ofMarch 31, 2021 , compared to 1.4% as ofDecember 31, 2020 . Noninterest-bearing deposits increased$172 million during the first three months of 2021, while interest-bearing checking accounts and money market deposit accounts increased$21.4 million and$62.0 million , respectively. The increases in these transactional deposit products largely reflect federal government stimulus, especially the PPP, as well as lower business investing and spending. Savings deposits were up$33.3 million during the first quarter of 2021, primarily reflecting the impact of federal government stimulus programs and lower consumer investing and spending. Local time deposits declined$39.4 during the first three months of 2021, in large part reflecting the maturity of certain time deposits that were not renewed during the quarter as we did not aggressively seek to renew these time deposits which were opened as part of a special time deposit campaign that primarily ran during the latter half of the first quarter of 2019. The reduction of out-of-area deposits during the first three months of 2021 reflects maturities not replaced as the funds were no longer needed. Sweep accounts increased$22.9 million during the first three months of 2021, totaling$141 million as ofMarch 31, 2021 . The aggregate balance of this funding type is subject to relatively large daily fluctuations given the nature of the customers utilizing this product and the sizable balances maintained by many of the customers. The average balance of sweep accounts equaled$133 million during the first quarter of 2021, with a high balance of$169 million and a low balance of$113 million . Our sweep account program entails transferring collected funds from certain business noninterest-bearing checking accounts and savings deposits into over-night interest-bearing repurchase agreements. Such sweep accounts are not deposit accounts and are not afforded federal deposit insurance, and are accounted for as secured borrowings. FHLBI advances aggregated$394 million as ofMarch 31, 2021 , unchanged from the year-end 2020 balance. The advances are collateralized by residential mortgage loans, first mortgage liens on multi-family residential property loans, first mortgage liens on commercial real estate property loans, and substantially all other assets of our bank, under a blanket lien arrangement. Our borrowing line of credit as ofMarch 31, 2021 totaled$737 million , with remaining availability based on collateral equaling$373 million . Shareholders' equity was$441 million atMarch 31, 2021 , compared to$442 million atDecember 31, 2020 . Shareholders' equity was positively impacted by first quarter net income of$14.2 million , which was offset by the$4.6 million payment of a cash dividend, stock repurchases aggregating$3.5 million , and a$7.2 million after-tax decline in the market value of our available for sales securities portfolio. The latter reflects the impact of increasing interest rates during the first three months of 2021. -------------------------------------------------------------------------------- 59
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Liquidity
Liquidity is measured by our ability to raise funds through deposits, borrowed funds, and capital, or cash flow from the repayment of loans and securities. These funds are used to fund loans, meet deposit withdrawals, maintain reserve requirements and operate our company. Liquidity is primarily achieved through local and out-of-area deposits and liquid assets such as securities available for sale, matured and called securities, federal funds sold and interest-earning deposits. Asset and liability management is the process of managing our balance sheet to achieve a mix of earning assets and liabilities that maximizes profitability, while providing adequate liquidity. To assist in providing needed funds, we periodically obtain monies from wholesale funding sources. Wholesale funds, primarily comprised of deposits from customers outside of our market areas and advances from the FHLBI, totaled$425 million , or 10.1% of combined deposits and borrowed funds, as ofMarch 31, 2021 , compared to$441 million , or 11.2% of combined deposits and borrowed funds, as ofDecember 31, 2020 . Sweep accounts increased$22.9 million during the first three months of 2021, totaling$141 million as ofMarch 31, 2021 . The aggregate balance of this funding type is subject to relatively large daily fluctuations given the nature of the customers utilizing this product and the sizable balances maintained by many of the customers. The average balance of sweep accounts equaled$133 million during the first quarter of 2021, with a high balance of$169 million and a low balance of$113 million . Our sweep account program entails transferring collected funds from certain business noninterest-bearing checking accounts and savings deposits into over-night interest-bearing repurchase agreements. Such sweep accounts are not deposit accounts and are not afforded federal deposit insurance, and are accounted for as secured borrowings. Information regarding our repurchase agreements as ofMarch 31, 2021 and during the first three months of 2021 is as follows: Outstanding balance atMarch 31, 2021 $
141,310,000
Weighted average interest rate atMarch 31, 2021 0.11 % Maximum daily balance three months endedMarch 31, 2021 $
169,102,000
Average daily balance for three months endedMarch 31, 2021 $
132,845,000
Weighted average interest rate for three months ended
0.11 % FHLBI advances aggregated$394 million as ofMarch 31, 2021 , unchanged from the year-end 2020 balance. The advances are collateralized by residential mortgage loans, first mortgage liens on multi-family residential property loans, first mortgage liens on commercial real estate property loans, and substantially all other assets of our bank, under a blanket lien arrangement. Our borrowing line of credit as ofMarch 31, 2021 totaled$737 million , with remaining availability based on collateral equaling$373 million . We also have the ability to borrow up to an aggregate$70.0 million on a daily basis through correspondent banks using established unsecured federal funds purchased lines of credit. We did not access these lines of credit during the first three months of 2021. In contrast, our interest-earning deposit balance with theFederal Reserve Bank of Chicago and a correspondent bank averaged an aggregate$587 million during the first three months of 2021. We also have a line of credit through the Discount Window of theFederal Reserve Bank of Chicago . Using certain municipal bonds as collateral, we could have borrowed up to$35.2 million as ofMarch 31, 2021 . We did not utilize this line of credit during the first three months of 2021 or at any time during the previous twelve fiscal years, and do not plan to access this line of credit in future periods. -------------------------------------------------------------------------------- 60
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-------------------------------------------------------------------------------- The following table reflects, as ofMarch 31, 2021 , significant fixed and determinable contractual obligations to third parties by payment date, excluding accrued interest: One Year One to Three to Over or Less Three Years Five Years Five Years Total Deposits without a stated maturity$ 3,145,254,000 $ 0 $ 0 $ 0$ 3,145,254,000 Time deposits 303,175,000 166,642,000 29,891,000 0 499,708,000 Short-term borrowings 141,310,000 0 0 0 141,310,000 Federal Home Loan Bank advances 40,000,000 174,000,000 120,000,000 60,000,000 394,000,000 Subordinated debentures 0 0 0 47,733,000 47,733,000 Other borrowed money 0 0 0 1,629,000 1,629,000 Property leases 634,000 1,272,000 373,000 1,182,000 3,461,000 In addition to normal loan funding and deposit flow, we must maintain liquidity to meet the demands of certain unfunded loan commitments and standby letters of credit. As ofMarch 31, 2021 , we had a total of$1.40 billion in unfunded loan commitments and$25.9 million in unfunded standby letters of credit. Of the total unfunded loan commitments,$1.22 billion were commitments available as lines of credit to be drawn at any time as customers' cash needs vary, and$177 million were for loan commitments generally expected to close and become funded within the next 12 to 18 months. We regularly monitor fluctuations in loan balances and commitment levels, and include such data in our overall liquidity management. We monitor our liquidity position and funding strategies on an ongoing basis, but recognize that unexpected events, changes in economic or market conditions, a reduction in earnings performance, declining capital levels or situations beyond our control could cause liquidity challenges. While we believe it is unlikely that a funding crisis of any significant degree is likely to materialize, we have developed a comprehensive contingency funding plan that provides a framework for meeting liquidity disruptions.
Capital Resources
Shareholders' equity was$441 million atMarch 31, 2021 , compared to$442 million atDecember 31, 2020 . Shareholders' equity was positively impacted by first quarter net income of$14.2 million , which was offset by the$4.6 million payment of a cash dividend, stock repurchases aggregating$3.5 million , and a$7.2 million after-tax decline in the market value of our available for sales securities portfolio. The latter reflects the impact of increasing interest rates during the first three months of 2021. As part of a$20 million common stock repurchase program announced in May of 2019, we repurchased approximately 118,000 shares for$3.5 million , at a weighted average all-in cost per share of$29.91 , during the first quarter of 2021. Since the beginning of the common stock repurchase program throughMarch 31, 2021 , we had repurchased approximately 469,000 shares for$13.7 million , at a weighted average all-in cost of$29.24 . The stock buybacks have been funded from cash dividends paid to us from our bank. Additional repurchases may be made during in future periods under the authorized plan, which would also likely be funded from cash dividends paid to us from our bank. We and our bank are subject to regulatory capital requirements administered by state and federal banking agencies. Failure to meet the various capital requirements can initiate regulatory action that could have a direct material effect on the financial statements. Under the finalBASEL III capital rules that became effective onJanuary 1, 2015 , there is a requirement for a common equity Tier 1 capital conservation buffer of 2.5% of risk-weighted assets which is in addition to the other minimum risk-based capital standards in the rule. Institutions that do not meet this required capital buffer will become subject to progressively more stringent limitations on the percentage of earnings that can be paid out in cash dividends or used for stock repurchases and on the payment of discretionary bonuses to senior executive management. The capital buffer requirement was phased in over three years beginning in 2016. The capital buffer requirement raised the minimum required common equity Tier 1 capital ratio to 7.0%, the Tier 1 capital ratio to 8.5% and the total capital ratio to 10.5% on a fully phased-in basis onJanuary 1, 2019 . We believe that, as ofMarch 31, 2021 , our bank met all capital adequacy requirements under theBASEL III capital rules on a fully phased-in basis. -------------------------------------------------------------------------------- 61
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-------------------------------------------------------------------------------- As ofMarch 31, 2021 , our bank's total risk-based capital ratio was 13.3%, compared to 13.5% atDecember 31, 2020 . Our bank's total regulatory capital increased$10.1 million during the first three months of 2021, in large part reflecting the net impact of net income totaling$15.5 million and cash dividends paid to us aggregating$6.5 million . Our bank's total risk-based capital ratio was also impacted by a$135 million increase in total risk-weighted assets, primarily resulting from net growth in commercial loans and the securities portfolio. As ofMarch 31, 2021 , our bank's total regulatory capital equaled$467 million , or$115 million in excess of the 10.0% minimum that is among the requirements to be categorized as "well capitalized." Our and our bank's capital ratios as ofMarch 31, 2021 andDecember 31, 2020 are disclosed in Note 12 of the Notes to Consolidated Financial Statements.
Results of Operations
We recorded net income of$14.2 million , or$0.87 per basic and diluted share, for the first quarter of 2021, compared to net income of$10.7 million , or$0.65 per basic and diluted share, for the first quarter of 2020. The improved level of net income primarily resulted from increased noninterest income, which more than offset decreased net interest income and higher noninterest expense. The increased noninterest income primarily reflected higher mortgage banking income. The decline in net interest income depicted a lower yield on earning assets, which more than offset growth in earning assets, while the higher level of noninterest expense mainly resulted from increased compensation costs. Interest income during the first quarter of 2021 was$34.8 million , a decrease of$3.1 million , or 8.3%, from the$37.9 million earned during the first quarter of 2020. The decrease resulted from a lower yield on average earning assets, which more than offset the impact of growth in average earning assets. The yield on average earning assets was 3.26% during the first quarter of 2021, compared to 4.54% during the prior-year first quarter. The decreased yield primarily resulted from a lower yield on loans, which declined from 4.69% during the first quarter of 2020 to 4.03% during the current-year first quarter. The decrease in loan yield was mainly due to a lower yield on commercial loans, which equaled 4.07% in the first quarter of 2021 compared to 4.76% in the prior-year first quarter. The lower yield primarily reflected reduced interest rates on variable-rate commercial loans resulting from theFOMC significantly decreasing the targeted federal funds rate by a total of 150 basis points in March of 2020. A change in earning asset mix and decreased yields on securities and interest-earning deposits also contributed to the lower yield on average earning assets in the current-year first quarter compared to the respective 2020 period. On average, lower-yielding interest-earning deposits represented 13.7% of earning assets during the first quarter of 2021, up from 4.6% during the first quarter of 2020, while higher-yielding loans represented 76.6% of earning assets during the current-year first quarter, down from 85.2% during the prior-year first quarter. A significant volume of excess on-balance sheet liquidity, which initially surfaced in the second quarter of 2020 as a result of the Covid-19 environment and persisted during the remainder of 2020 and the first three months of 2021, negatively impacted the yield on average earning assets by 44 basis points during the first quarter of 2021. The excess funds, consisting primarily of low-yielding deposits with theFederal Reserve Bank of Chicago , are mainly a product of federal government stimulus programs as well as lower business and consumer spending and investing. The yield on securities was 1.61% during the first three months of 2021, down from 4.73% during the respective 2020 period mainly due to decreased accelerated discount accretion on calledU.S. Government agency bonds and lower yields on newly-purchased bonds, reflecting the declining interest rate environment. Accelerated discount accretion totaled less than$0.1 million during the first quarter of 2021, compared to$1.8 million during the prior-year first quarter. As part of our interest rate risk management program,U.S. Government agency bonds are periodically purchased at discounts during rising interest rate environments; if these bonds are called during decreasing interest rate environments, the remaining unaccreted discount amounts are immediately recognized as interest income. The yield on interest-earning deposits was 0.11% during the first quarter of 2021, down from 1.22% during the first quarter of 2020, primarily reflecting the decreased interest rate environment. Average earning assets equaled$4.33 billion during the current-year first quarter, up$970 million , or 28.9%, from the level of$3.36 billion during the respective 2020 period; average loans were up$457 million , average interest-earning deposits were up$438 million , and average securities were up$74.6 million . -------------------------------------------------------------------------------- 62
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-------------------------------------------------------------------------------- Interest expense during the first quarter of 2021 was$5.3 million , a decrease of$2.3 million , or 31.0%, from the$7.6 million expensed during the first quarter of 2020. The decrease in interest expense is attributable to a lower weighted average cost of interest-bearing liabilities, which equaled 0.82% in the current-year first quarter compared to 1.36% in the prior-year first quarter. The decrease in the weighted average cost of interest-bearing liabilities mainly reflected lower costs of deposit accounts and borrowed funds. The cost of interest-bearing non-time deposit accounts decreased from 0.46% during the first quarter of 2020 to 0.21% during the first quarter of 2021, primarily reflecting lower interest rates paid on money market accounts; the reduced interest rates mainly reflect the decreasing interest rate environment. The cost of time deposits declined from 2.21% during the first quarter of 2020 to 1.49% during the current-year first quarter due to lower interest rates paid on local time deposits, reflecting the decreasing interest rate environment, and a change in composition, primarily reflecting a decrease in higher-cost brokered funds. The cost of borrowed funds decreased from 2.31% during the first quarter of 2020 to 1.78% during the first quarter of 2021, mainly reflecting lower costs of FHLBI advances and subordinated debentures. The cost of FHLBI advances was 2.06% during the first quarter of 2021, down from 2.40% during the prior-year first quarter, primarily reflecting the declining interest rate environment and the impact of a blend and extend transaction that was executed inJune 2020 with the FHLBI to extend the duration of our advance portfolio as part of our interest rate risk management program. The cost of subordinated debentures was 3.85% during the first quarter of 2021, down from 5.90% during the respective 2020 period due to decreases in the 90-Day Libor Rate . A change in funding mix, consisting of an increase in average lower-cost interest-bearing non-time deposits and a decrease in average higher-cost time deposits as a percentage of average total interest-bearing liabilities, also contributed to the lower weighted average cost of interest-bearing liabilities during the first quarter of 2021 compared to the prior-year first quarter. Average interest-bearing liabilities were$2.60 billion during the first quarter of 2021, up$362 million , or 16.1%, from the$2.24 billion average during the first quarter of 2020. Net interest income during the first quarter of 2021 was$29.5 million , a decrease of$0.8 million , or 2.6%, from the$30.3 million earned during the respective 2020 period. The decline in net interest income resulted from a decreased net interest margin, which more than offset the positive impact of an increase in average earning assets. The net interest margin decreased from 3.63% in the first quarter of 2020 to 2.77% in the current-year first quarter due to a lower yield on average earning assets, which more than offset a reduction in the cost of funds. The decreased yield on average earning assets primarily reflected lower interest rates on variable-rate commercial loans stemming from the aforementionedFOMC rate cuts, while the decreased cost of funds mainly reflected lower rates paid on local deposit accounts and borrowed funds, along with the previously mentioned change in funding mix. The decrease in the net interest margin from 3.00% in the fourth quarter of 2020 to 2.77% in the first quarter of 2021 reflected a lower yield on average earning assets, which more than offset a decline in the cost of funds. The yield on average earning assets was 3.26% during the first quarter of 2021, down from 3.55% during the fourth quarter of 2020, mainly due to a decreased yield on commercial loans, which equaled 4.07% and 4.41% in the respective periods. The decreased yield on commercial loans primarily reflected reduced PPP net loan fee accretion stemming from a lower level of forgiveness activity. Net PPP loan fee accretion totaled$2.8 million in the first quarter of 2021, compared to$5.4 million during the fourth quarter of 2020. The cost of funds declined from 0.55% during the fourth quarter of 2020 to 0.49% during the first quarter of 2021, mainly due to lower rates paid on renewed time deposits, reflecting the declining interest rate environment, and a change in funding mix, consisting of an increase in lower-costing non-time deposits as a percentage of total funding sources.
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-------------------------------------------------------------------------------- The following table sets forth certain information relating to our consolidated average interest-earning assets and interest-bearing liabilities and reflects the average yield on assets and average cost of liabilities for the first quarters of 2021 and 2020. Such yields and costs are derived by dividing income or expense by the average daily balance of assets or liabilities, respectively, for the period presented. Tax-exempt securities interest income and yield for the first quarters of 2021 and 2020 have been computed on a tax equivalent basis using a marginal tax rate of 21.0%. Securities interest income was increased by$60,000 in the first quarter of both 2021 and 2020 for this non-GAAP, but industry standard, adjustment. This adjustment equated to a one basis point increase in our net interest margin during both the first quarter of 2021 and the respective 2020 period. Quarters ended March 31, 2 0 2 1 2 0 2 0 Average Average Average Average Balance Interest Rate Balance Interest Rate (dollars in thousands) ASSETS Loans$ 3,318,281 $ 32,985 4.03 %$ 2,861,047 $ 33,442 4.69 % Investment securities 419,514 1,692 1.61 344,906 4,077 4.73 Other interest-earning assets 591,617 168 0.11 153,638 475 1.22
Total interest - earning assets 4,329,412 34,845 3.26
3,359,591 37,994 4.54 Allowance for loan losses (38,467 ) (23,710 ) Other assets 287,942 266,903 Total assets$ 4,578,887 $ 3,602,784 LIABILITIES AND SHAREHOLDERS' EQUITY Interest-bearing deposits$ 2,026,896 $ 2,717 0.54 %$ 1,724,030 $ 4,641 1.08 % Short-term borrowings 132,845 36 0.11 102,850 40 0.15
365,429 2,212 2.40 Other borrowings 49,801 472 3.79 49,682 724 5.77 Total interest-bearing liabilities 2,603,542 5,252 0.82
2,241,991 7,617 1.36
Noninterest-bearing deposits 1,510,334 923,827 Other liabilities 21,463 17,355 Shareholders' equity 443,548 419,611 Total liabilities and shareholders' equity$ 4,578,887 $ 3,602,784 Net interest income$ 29,593 $ 30,377 Net interest rate spread 2.44 % 3.18 % Net interest spread on average assets 2.62 % 3.38 % Net interest margin on earning assets 2.77 % 3.63 %
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MERCANTILE BANK CORPORATION
-------------------------------------------------------------------------------- A loan loss provision expense of$0.3 million was recorded during the first quarter of 2021, compared to$0.8 million during the first quarter of 2020. The provision expense recorded during both periods primarily reflected net loan growth. The recording of net loan recoveries in both periods reduced the required provision amounts. During the first quarter of 2021, loan charge-offs totaled$0.1 million , while recoveries of prior period loan charge-offs equaled$0.5 million , providing for net loan recoveries of$0.4 million , or an annualized 0.05% of average total loans. During the first quarter of 2020, loan charge-offs totaled less than$0.1 million , while recoveries of prior period loan charge-offs equaled$0.2 million , providing for net loan recoveries of$0.2 million , or an annualized 0.03% of average total loans. The allowance for loans, as a percentage of total loans, was 1.2% as ofMarch 31, 2021 , andDecember 31, 2020 , and 0.9% as ofMarch 31, 2020 . Excluding PPP loans, the allowance for loans represented 1.3% of total loans as ofMarch 31, 2021 , andDecember 31, 2020 . Noninterest income during the first quarter of 2021 was$13.5 million , an increase of$6.9 million , or approximately 106%, from the prior-year first quarter. The improved level of noninterest income primarily resulted from increased mortgage banking income, reflecting a significant increase in refinance activity driven by a decrease in residential mortgage loan interest rates, a higher level of purchase activity, the continuing success of strategic initiatives that were implemented to increase market share, including new lender hires and loan production office openings, an increase in the percentage of originated loans being sold, and a higher gain on sale margin influenced by market dynamics. Mortgage banking income totaled$8.8 million during the first quarter of 2021, representing an increase of$6.2 million , or nearly 235%, from the$2.6 million earned during the respective 2020 period. We originated$245 million in residential mortgage loans during the first three months of 2021, which was approximately 85% higher than originations during the first three months of 2020. Refinance transactions totaled$164 million during the first quarter of 2021, compared to$86.3 million during the respective 2020 period, representing an increase of$77.4 million , or approximately 90%. Purchase transactions totaled$81.5 million during the first three months of 2021, compared to$46.5 million during the first three months of 2020, representing an increase of$35.0 million , or approximately 75%. Residential mortgage loans originated for sale, generally consisting of longer-term fixed rate residential mortgage loans, totaled$196 million , or approximately 80% of total mortgage loans originated, during the first quarter of 2021. During the prior-year first quarter, residential mortgage loans originated for sale totaled$95.3 million , or nearly 72% of total mortgage loans originated. Fee income generated from an interest rate swap program that was implemented during the fourth quarter of 2020 and growth in credit and debit card income also contributed to the increased level of noninterest income. The interest rate swap program provides certain commercial borrowers with a longer-term fixed-rate option and assists us in managing associated longer-term interest rate risk. Increased customer deposit account balances, in large part reflecting federal government stimulus programs and reduced business and consumer investing and spending and resulting in a higher level of account fees being waived, have continued to negatively impact service charges on accounts, which were down 5.5% in the first quarter of 2021 compared to the prior-year first quarter. Payroll processing fees declined 3.5% during the first three months of 2021 compared to the respective 2020 period, mainly reflecting decreased transaction volume stemming from the Coronavirus Pandemic-related increase in the unemployment rate. Noninterest expense totaled$25.1 million during the first quarter of 2021, compared to$22.9 million during the first quarter of 2020. Overhead costs during the first three months of 2021 included write-downs of former branch facilities totaling$0.5 million . Excluding these transactions, noninterest expense increased$1.6 million , or 7.1%, during the first quarter of 2021 compared to the respective 2020 period. The higher level of expense primarily resulted from increased compensation costs, mainly depicting higher residential mortgage lender commissions and related incentives, annual employee merit pay increases, increased health insurance costs, and a bonus accrual. The higher level of commissions and associated incentives primarily reflected the significant increase in residential mortgage loan originations during the first quarter of 2021, which were up nearly 85% compared to the respective 2020 period. No bonus accrual was recorded during the first quarter of 2020 due to the Coronavirus Pandemic and associated weakened economic environment. An increase inFederal Deposit Insurance Corporation deposit insurance premiums from$0.2 million during the first quarter of 2020 to$0.4 million during current-year first quarter, mainly reflecting the impacts of a higher assessment rate and base, also contributed to the increased level of noninterest expense. During the first quarter of 2021, we recorded income before federal income tax of$17.6 million and a federal income tax expense of$3.3 million . During the first quarter of 2020, we recorded income before federal income tax of$13.2 million and a federal income tax expense of$2.5 million . The increase in federal income tax expense during the first quarter of 2021 compared to the prior-year first quarter resulted from the higher level of income before federal income tax. Our effective tax rate was 19.0% during both the first three months of 2021 and the respective 2020 period. -------------------------------------------------------------------------------- 65
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Table of ContentsMERCANTILE BANK CORPORATION
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