Good morning, and welcome to the Mercantile Bank Corporation First Quarter 2020 Earnings Results Conference Call. All participants will be in listen-only mode. After today’s presentation, there will be an opportunity to ask questions. Please note this event is being recorded. I would now like to turn the conference over to Mike Houston, Investor Relations. Please go ahead.

Thank you, Grant. Good morning, everyone, and thank you for joining Mercantile Bank Corporation's conference call and webcast to discuss the company's financial results for the first quarter 2020. I'm Mike Houston, with Lambert IR, Mercantile's Investor Relations firm. And joining me today are members of their management team including Bob Kaminski, President and Chief Executive Officer; Chuck Christmas, Executive Vice President and Chief Financial Officer; and Ray Reitsma, President of Mercantile Bank, Michigan. We will begin the call with management's prepared remarks and presentation to review the quarter's results then open the call up to questions. However, before we begin today's call, it is my responsibility to inform you that this call may involve certain forward-looking statements such as projections of revenue, earnings, and capital structure as well as statements on the plans and objectives of the company's business. The company's actual results could differ materially from any forward-looking statements made today due to the 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 the call. If anyone does not already have a copy of the first quarter 2020 press release and presentation deck issued by Mercantile today, you can access it at the company's website www.mercbank.com. At this time, I'd like to turn the call over to Mercantile's President and Chief Executive Officer, Bob Kaminski. Bob?

Thanks, Mike, and good morning, everyone. At the conclusion of our call in January, when we told you that we look forward to speaking with you in April, none of us could have imagined how our world was going to change in just a few short months. On the call this morning, we will provide details of our performance for the first quarter as usual, but we will also spend a significant amount of time in our comments discussing the items, which we believe will be of interest to you in the wake of the COVID-19 pandemic. COVID-19 has obviously created a life-threatening crisis around the globe. As February ended, it became more and more apparent that the virus was rapidly spreading in the United States, and action had to be taken. First and foremost, Mercantile worked expeditiously to ensure the health and safety of our employees and customers, and our detailed response is noted on slide 3 of the presentation. As concerns over the pandemic in the U.S. and Michigan started to grow, Mercantile worked to limit face-to-face contact with our customers beginning on March 18, eventually leading us to the full closure of our lobbies with Governor Whitmer's stay-at-home order on March 25. Customers are able to continue fulfilling their banking needs with our drive-thru facilities, video banking machines, and electronic banking. Since the beginning of the crisis, for example, our daily retail online banking logins have almost doubled. Regarding our staff, as mentioned on slide 3, since March 23, on any day we generally have over 75% of all employees working remotely from home. Some of the gracious feedback from our customers can be seen on slide 4. As we have discussed in recent years, Mercantile has worked continuously since the end of the Great Recession to place ourselves in a position of strength. The goal is to leverage the opportunities of a solid economy, but to also provide our company with strong financial metrics that allow us to be successful during weaker economic times. While the pandemic certainly creates new challenges for everyone in the financial services industry, our foundation remains extremely solid as we work with our clients to help them weather the storm caused by this crisis. During this call, we will be providing you with details on our loan portfolio, including metrics on some areas of focus as we work through the issues presented to our industry. We'll talk about our historical credit quality leading up to the crisis, loan concentrations including breakdown by loan type as well as non-owner-occupied real estate versus owner-occupied real estate, and our C&I portfolio by industry classification. We will also discuss activity with our clients relative to our payment relief program for existing loans during the pandemic. We'll also talk about our efforts to provide funds to our clients through the SBA’s Paycheck Protection Program. We'll discuss our key metrics including liquidity and capital position as well as the position Mercantile is taking regarding the new rules that allow the postponement of the adoption of CECL. We will discuss the impact on our net interest margin by the actions taken by the FOMC at the start of the crisis to boost the economy. With cuts in interest rates, our mortgage banking business has been able to generate record pipeline volumes comprised primarily of refinances. The stay-at-home mandate is making the new purchase activity quite challenging at the current time, but real estate agents and consumers are trying to be creative with real estate movement while maintaining compliance with the executive orders. Michigan has unfortunately been a hotspot for COVID cases. Southeast Michigan, including the City of Detroit, is a large metropolitan area that has been hit very hard with confirmed cases and deaths skyrocketing in early April. The areas of the state where Mercantile maintains the vast majority of its market presence, including Kent County and West Michigan along with the central part of the state, have seen critical statistics increasing, but at levels allowing the healthcare systems to keep pace with the spread. Social distancing, in conjunction with the state mandate, has caused citizens to remain at home with the exception of those working in essential critical industries. Many local businesses have engaged in federal stimulus relief to help keep their employees paid as their state waits for the virus cases to subside so the economy can be safely reopened. Before this crisis, the Michigan economy was generally steady throughout 2019. Some areas of manufacturing had a down year, but unemployment was low, real estate prices continued to increase, and the tourism industry continued to exhibit strength. It is certainly everyone's hope that as infections from the virus subside and plans for lifting the restrictions on movement in our communities are implemented, the economy, which is the driving force, the consumer, returns with ample energy to jump-start businesses that have been placed in hibernation. We'll continue to monitor the situations closely and be prepared to take additional measures if those needs arise. As always, we remain confident in our positioning that continues to strongly serve our customers as we navigate through and eventually out of this ever-changing environment. Those are my introductory comments. I'll now turn it over to Ray.

Thanks, Bob. Our loan portfolio increased $45 million in the first quarter of 2020, with each of our markets contributing to that growth. Our pipeline remains solid as well, with $77 million of commitments in commercial construction and development loans, which we expect to fund over the next 12 to 18 months should a semblance of normal construction activity resume during that timeframe. Our asset quality remains strong as non-performing assets totaled $3.7 million, or one-tenth of 1% of total assets at March 31. We recorded non-interest income during the fourth quarter of $6.5 million, up $1.8 million, or 38% from the prior year first quarter, excluding $1.9 million in non-recurring items related to that quarter. This improved level of non-interest income was largely driven by increased mortgage banking income, reflecting the success of ongoing strategic initiatives designed to increase market share and a higher level of refinance activities stemming from a recent decrease in rates continuing to enhance mortgage banking income through increased market share, including an increased share in the purchase market remains a priority and we will continue to hire proven mortgage loan originators when we are able. We also recorded continued growth in the quarter in other fee income categories including credit and debit card income, service charges on accounts, and payroll processing fees. Credit and debit card income has trended downward as stay-at-home orders were implemented in March and are scheduled to remain in effect through April 30. The exercise of discipline related to overhead costs as we focus on efficient delivery systems in all of our lines of business remains a priority. The onslaught of the COVID-19 virus provided an opportunity to demonstrate the value of community banking, combining high-touch service with strong capabilities. As Bob mentioned, our electronic banking capability allowed us to close our lobbies on March 25 and contributed to our ability to have three-quarters of our employees work from home from that date forward. While many banks labored under the SBA Paycheck Protection Program, Mercantile funded over 1,500 applications representing over $500 million in loans, supporting thousands of workers in our communities and contributing to the maintenance of asset quality as the crisis plays out. Our communities have been consistent in providing us with supportive feedback, praising our commitment to professionalism throughout the process. Some of this gracious feedback from our customers can be found on slide 4 of the presentation, as Bob mentioned. In addition to the federally funded SBA programs, as you can see on slide 5, Mercantile created payment deferral programs allowing interest-only programs and total payment deferral programs for entities directly impacted by the COVID-19 crisis. Next, on slide 6, while consumer lending is a small proportion of our portfolio at approximately $30 million, over 500 hardship inquiries have been logged by our customer service team and less than 50 cases have our customers requested implementation. Our past due list on slide 7 has maintained the proportions of the pre-crisis world as of March 31 and to date in April as well. The risk rating process, as seen in the next slides, reflects a portfolio of strong characteristics, reflecting the strength of the pre-crisis economy. Maintaining accurate risk ratings will remain a key focus in the upcoming quarters. We will be paying particular attention to the financial condition and performance of credits in the following segments: automotive dealerships, hotels and lodging, assisted living, restaurants, construction, movie theatres, and retail. None of these individual segments account for more than 5% of the commercial loans. Turning to slide 11, we will go over some of the details of the recent programs implemented by the CARES Act and the Federal Reserve. The Paycheck Protection Program provides for forgivable loans to eligible small businesses to maintain employment during this pandemic. The loans carry a 1% interest rate and deferred payments for the first six months and monthly payments for the following 18 months. The loans may be forgiven if the funds are used by the borrower for payroll, rent, and utilities in the specified proportions. The SBA also provides an origination fee of between 1% and 5%, which is paid within five days of closing. The deferred income is accretive to interest income over the life of the loan, with accelerated accretion if the loan is paid off or forgiven. These resulted in an effective yield enhancement of 2.5%. To fund these loans, the Federal Reserve is providing term advances, which you can see on Slide 12. These advances allow us to borrow dollar-for-dollar on the PPP loans with a fixed rate of 35 basis points. The advances are required to be repaid as forgiveness and payments are received from the SBA or as the borrower repays the loan over the 24-month term. That concludes my remarks. I'll now turn the call over to Chuck.

Thanks, Ray, and good morning, everybody. Starting on slide 13, this morning we announced net income of $10.7 million, or $0.65 per diluted share for the first quarter of 2020, compared with net income of $11.8 million, or $0.72 per diluted share for the first quarter of 2019. Proceeds from a bank-owned life insurance claim and a gain on the sale of a former branch facility increased net income in the prior year period by $1.8 million or $0.11 per diluted share. Excluding the impacts of these transactions, diluted earnings per share increased $0.04 or approximately 7% during the current year first quarter compared to the prior year first quarter. Moving to slide 14, interest income on loans declined due to the FOMC rate cuts aggregating 225 basis points since the beginning of the third quarter in 2019, with 150 basis points of those cuts occurring in the first quarter of 2020. Interest income on securities benefited from a $1.8 million in accelerated discount accretion from called U.S. Government agency bonds during the first quarter of 2020. In total, interest income was down $0.7 million during the first quarter of 2020 compared to the first quarter of 2019, or down $2.5 million if the accelerated discount accretion is excluded. Interest expense declined in all categories during the first quarter of 2020 when compared to the first quarter of 2019, reflecting the declining interest rate environment. Net interest income declined $0.3 million during the first quarter of 2020 compared to the first quarter of 2019, or $2.1 million if the accelerated discount accretion is excluded. Provision expense totaled $750,000 during the first quarter of 2020, relatively similar to the $850,000 we expensed during the first quarter 2019. We elected to postpone the adoption of CECL as permitted by the CARES Act. As you know, an economic forecast is a key component of the CECL methodology. We are embarking into an unprecedented economic environment whereby a sizable portion of the economy has been significantly impacted by shelter-in-place declarations and similar reactions by businesses and individuals. Substantial government stimulus has been provided to businesses, individuals, and state and local governments. Financial institutions have offered businesses and individuals payment relief options. Economic forecasts are regularly updated, and there is no economic forecast consensus. Given the high degree of uncertainty surrounding economic forecasting, we have elected to continue to utilize our incurred loan loss reserve model for the time being, updating loss migration calculations and modifying them as necessary to the nine environmental factors at each quarter end. First quarter 2020 provision expense reflects a combination of loan growth, an economic environment allocation change, and a reduction of specific allocations on uncertain fully collected lending relationships. Moving on to slide 15, total fee income during the first quarter of 2020 was similar to fee income recorded during the first quarter of 2019. However, if the aforementioned bank-owned life insurance claim and former branch facility gain on sale are excluded, fee income during the first quarter increased by $1.8 million or 38%. Mortgage banking income expanded by about 150%, reflecting increased refinancing activity during the latter part of the quarter and the successful implementation of several strategic initiatives, including the ongoing hiring of additional mortgage lenders. We also recorded 13% growth in service charge income, largely reflecting a higher treasury management income, and 14% growth in payroll processing income due to an expanded client base. On page 16, overhead costs increased $1.1 million during the first quarter of 2020 compared to the first quarter of 2019. Salary and benefit costs were up $0.5 million, reflecting merit pay increases and higher mortgage lender commissions. Occupancy, furniture, and equipment costs were up a combined $0.4 million, largely reflecting the Fall of 2019 completion of our main office expansion. On slide 17, our net interest margin was 3.63% during the first quarter of 2020, unchanged from the fourth quarter of 2019 and down 25 basis points compared to the first quarter of 2019. The previously mentioned accelerated discount accretion on called U.S. government agency bonds had a 22 basis point positive impact on our yield on earning assets and net interest margin during the first quarter of this year. The yield on loans was down 32 basis points during the first quarter of 2020 compared to the fourth quarter of 2019 and down 52 basis points when compared to the first quarter of 2019, largely reflecting the aforementioned FOMC's aggregate 225 basis point reduction in the targeted federal funds rate. The cost of funds has also been on a declining trend, primarily reflecting the falling interest rate environment, but in terms of magnitude and scale, not to the degree experienced in our yield on loans. Excluding the impacts of the PPP loan and PPPLF programs, we forecast a lower net interest margin during the second quarter of 2020, as we experienced a full quarter impact of the FOMC's aggregate 150 basis point rate reduction in early March and then a relatively stable net interest margin for the remainder of 2020. On slide 18, our mortgage loan originations totaled almost $133 million during the first quarter of 2020, an $88 million or 195% increase compared to the first quarter of 2019. About 65% of the mortgage volume during the first quarter of 2020 consisted of refinance applications compared to only 33% during the first quarter of last year. Approximately 72% of the mortgage loan originations during the first quarter of 2020 have been or will be sold on the secondary market, that's up about 48% from a year ago. The net gain on the sale of mortgage loans was lower during the first quarter of this year, relative to our level of activity, reflecting the one-time impact of our decision to sell closed loans closer to the commitment expiration date, rather than soon after the closing date of the mortgage loan. The accelerated refinance activity did result in a higher level of mortgage servicing right amortization. However, as we use a lower of cost to market methodology, no valuation write-down was recorded. The estimated value of our mortgage servicing rights remains well above the carrying value at March 31. Moving on to slide 19. We remain a strong and well-capitalized regulatory capital position. The bank's Tier 1 leverage capital ratio was 11.3% and the total risk-based capital ratio was 12.9% as of March 31, 2020. The total risk-based capital ratio was over $94 million above the minimum thresholds being categorized as well capitalized. Share repurchase activity during the first quarter of 2020 totaled about 222,000 shares at a total cost of $6.3 million or $28.25 average per share price. In late March, we elected to suspend share repurchase activity due to the uncertainty surrounding the COVID-19 environment. We currently have about $10 million available in our current repurchase plan. Turning on slide 20 on some asset quality numbers. The overall quality of the loan portfolio remains very strong, with continued low levels of non-performing loans and loan charge-offs. Non-performing loans as a percent of average loans equaled only 12 basis points at the end of the quarter. The balance of other real estate owned was less than $300,000 at quarter end. Gross loan charge-offs totaled less than $100,000 during the first quarter of 2020, while recoveries of prior period loan charge-offs totaled over $200,000. The resulting net loan recovery of about $200,000 equated to three basis points of average total loans annualized. On slide 21, additions in non-performing assets totaled $1.3 million during the first quarter of 2020, in large part, reflecting purchased and peer residential mortgage loans. Due to materiality considerations, loan purchase accounting was in large part discontinued effective January 1, 2020. Therefore, these specific stressed residential mortgage loans are now reported as originated. Moving to slide 22. Due to the high degree of uncertainty that currently exists, we will not be providing earnings performance guidance as we have done on past conference calls. However, we are able to offer key considerations that should be factored into any earnings forecast of our company included in regards to net interest income, the 30-day LIBOR rate; 50% of floating rate commercial loans, or 25% of total commercial loans are tied to this index. We've repriced 30-day LIBOR-based loans on the first business day of each month, equal to the closing rate of the previous month-end, and then hold that rate constant for the entire month. While historically, the 30-day LIBOR rate has approximated the targeted federal funds rate, a credit risk premium has resulted in an elevated 30-day LIBOR rate. The 30-day LIBOR rate was 99 basis points at March 31, 2020, compared to a federal funds rate of 25 basis points. Interest income of commercial loans will be impacted to the degree the 30-day LIBOR rate fluctuates in future periods. PPP loan and PPP LF volume, PPP loan fundings are in excess of $500 million. SBA loan origination fees totaled in excess of $14 million. Direct loan origination costs aggregate about $1 million. It is likely that the PPP LF program will be used to fund a majority of the resulting deposit outflows, over the next six to 10 weeks. Net deferred SBA loan origination fees and direct loan origination costs will be accreted into interest income on loans over the life of the loans on a level yield method. PPP loans are underwritten for a 24-month period. The degree to which PPP loans are forgiven and the loans are effectively paid off by the SBA net deferred loan fee accretion will be accelerated. Accelerated discount accretion on callable U.S. government agency bonds totaled $1.8 million during the first quarter of 2020. Unaccreted discount aggregated $1.5 million, as of March 31. The degree to which discounted agency bonds are called discount accretion will be accelerated. And finally in asset quality and margin, the degree to which an increase in non-accrual loans is experienced loan interest income may be negatively impacted. For provision expense, net loan growth requires some level of reserve build via provision expense. The degree to which loans are downgraded, in accordance with our loan grading paradigm reserve building via provision expense may be necessary. The degree to which loans become impaired, due to being placed in non-accrual or TDR status, reserve building via provision expense may be necessary. The nine qualitative environmental reserve allocation factors are formally reviewed at each quarter-end. Any changes may have an impact on the required reserve calculation which may impact the provision expense. For fee income, Michigan's shelter-at-home declarations have had a substantial impact on the home purchase market. The degree to which changes in COVID-19 measures are made by Michigan's Governor are difficult to predict on our mortgage banking operations. Michigan's shelter-at-home declarations have also had a substantial impact on debit and credit card interchange fees as card use dropped. The degree to which changes in COVID-19 measures are made by the Michigan's Governor are difficult to predict on our debit and credit card operations. And lastly for overhead costs, Michigan's shelter-at-home declarations have had a substantial impact on various overhead costs such as employee meal and mileage reimbursements, as well as foreign ATM fee reimbursements. The degree to which changes in COVID-19 measures are made by Michigan's Governor are difficult to predict on various overhead costs. Any increase in problem loan relationships could result in an increase in collection costs. In closing, while there are many uncertainties that may impact Mercantile's financial condition and earnings performance in future periods, we note that we entered the stressed environment with strong asset quality and capital position. Those are my prepared remarks. I'll now turn the call back over to Bob.

Thank you, Chuck, and thank you, Ray. That now concludes management's prepared remarks. We'll now open the call up to the question-and-answer session.

Our first question comes from Brendan Nosal with Piper Sandler. Please go ahead.

Hey, good morning guys. How are you?

Good morning, Brendan, fine, and you?

Fine, first off I just wanted to thank you for the level of disclosure you guys offered in the slide deck; definitely very helpful. So on questions too, just starting off on the level of the reserve. I get that NPVs are pretty stable. Charge-offs were really benign, and you guys talked to delayed CECL implementation. But I guess even so, just kind of looking at the level of unemployment claims coming out of Michigan, it seems like it's one of the harder hit states. So just help me square up kind of the relatively stable reserve level versus the stress that we're seeing in the Michigan economy right now.

Yes. Brendan, as we discussed, reserve calculations have many variables. With the incurred model and the CECL model in play, I believe it's best to manage the process, especially given the considerable uncertainty in economic forecasting, which greatly affects calculations under CECL. Therefore, we decided to continue using the incurred model, which has worked well for us since 1997. While it is an incurred model that begins with migration, we consider various reserve environmental allocation factors, which we reviewed and adjusted at the end of March. We will depend heavily on those factors and need to observe how the current environment impacts our borrowers in the upcoming quarters. Michigan has indeed faced significant challenges, as Bob mentioned, but it's worth noting that the areas where Michigan has its primary presence haven't been as severely affected, with most cases located in Southeast Michigan. This does impact the overall economy of the state. Interestingly, when we adopted CECL, our initial calculation indicated a $700,000 reduction in our reserve. So, by not adopting CECL right away, we effectively increased our reserve by that same amount. Moving forward, we recognize that we are currently in a very stressed environment. We will work closely with our borrowers to understand their situations and make necessary downgrades. Executive management will continuously review and adjust the environmental factors in response to changing circumstances. We have already downgraded the economic factor to its lowest rating within our current system. Regarding the $700,000 reduction, it's important to note that around 85% of our loan portfolio consists of commercial loans, and our exposure in the consumer retail sector is minimal, primarily limited to mortgage lending. CECL is based on loan duration, and for our commercial loans, this averages just over two years, which leads to a lower reserve requirement. While the $700,000 reduction was calculated for day one, it is a net reduction. Our reserve calculations for commercial loans would have shown a more significant decline, but we experienced an increase from the mortgage loan allocations, leading to that total. This does not make much sense to our management team, and unfortunately, it's a limitation of CECL since renewals on commercial loans cannot be assumed. We maintain strong relationships with many commercial borrowers, which we anticipate will continue despite upcoming maturities. The decision against using CECL largely stemmed from uncertainties surrounding economic forecasts. The third-party provider we relied on for CECL modeling frequently updated its forecasts, resulting in dramatic changes that made it difficult to choose which to rely on. One of our controls for our CECL model was to ensure that we selected a third-party provider whose forecasts aligned with the prevailing consensus, given the lack of uniformity in economic forecasts. We were concerned about starting to use a new model that we believe has significant shortcomings amid this serious crisis. To clarify, we did not decide against CECL to reduce our provisioning expense. We are aware that other banks have reported substantial increases in provision expenses. However, those banks often have considerable consumer and retail loan exposure, which we do not face. As a commercial bank, we have maintained our traditional rating framework, which adds the nine environmental factors we will continue to rely on. If we detect considerable stress in our portfolio, we will downgrade affected credits and adjust our reserve calculations accordingly. Nevertheless, it's challenging to predict the exact impact on asset quality going forward due to the level of stimulus applied. We have over 1,500 clients awaiting PPP loans, which provide crucial cash flow for their key expenses. We are also offering mortgage borrowers payment options to help safeguard their cash flows, and similar deferral options to other commercial borrowers. While we are witnessing extensive stress across our markets, there are also a variety of stimulus programs that could alleviate the pressure on our borrowers. The critical question will be how long these impacts last. Our Governor has implemented aggressive measures reflecting the severe effects on Southeast Michigan; there is no dispute about the necessity of those actions. However, the timing and extent to which these measures might be lifted in the coming months will have a significant impact on our asset quality. In the interim, we will continue to monitor our portfolio closely, assess the quality of our loan portfolio, and make provision expense adjustments as necessary.

All right. Thank you so much for all of your thoughts there. I certainly appreciate all of the problems of adopting CECL, especially in light of an unprecedented environment. Just a follow up to those comments. If we are on the old incurred loss methodology and kind of credit migration is such a big component of what provision expense in the open reserves should be, I mean could the actions that you guys have taken and other banks have taken, whether it's forbearance or deferrals, does that slow down the trajectory of migration such that reserve building is pushed out even further as those credits are under a deferral?

Yes, I should have emphasized in my earlier response that our bank, along with many others, has experienced very minimal losses over the past five to seven years. If you examine our migration calculations, you'll find that many of our loan categories, even those rated four or five, have little to no allocation. Some time ago, we implemented minimum reserve allocation factors for our five main categories of commercial loans, which significantly increased the reserves we needed to hold. Although our migration figures are quite low, we established these minimum calculations. This was a key distinction between our incurred model and our CECL model, which does not permit these minimum reserve allocation factors. The decline in reserve allocations between incurred and CECL models was primarily due to the removal of these minimum numbers. We believe it is important to include some minimum numbers in our reserve calculations, considering our strong asset quality over the past several years, which has influenced our migration. Regarding your second question, we will continue to engage with our borrowers. Our lenders are in regular communication with them. If it becomes necessary to downgrade credits based on these discussions, we will do so, although it will take time for the situation to unfold. Every customer will be affected differently, so it’s challenging to generalize. Particularly in commercial lending, each borrowing relationship is unique and needs individual assessment, which is why we have a grading system that underpins our reserve balance.

Yes. Brendan, this is Bob. I'll add to what Chuck said and just reemphasize what he said earlier that our loan loss reserve methodology has served us very well over the years during good economic times and under challenged economic times. And we'll see how it all plays out with CECL over the next couple of years as to the adoption and the eventual adoption of that by all banks. But we feel really good about our methodology. We feel really good that our customers are very solid going into this crisis. They were across the board. The portfolio had great strength, and I think that will serve them and us very well as we work through this crisis and whatever comes down the road as a result of the shutdown of our economy. So that's very fortunate that we had that strength going in. But as Chuck said, we'll continue to analyze each customer and look at their situation, understanding where their revenues are coming from and the economy eventually gets reopened here in Michigan. And I think the Governor and all legislators are working on that to make sure that we don't go overboard with the restrictions, but make sure that we continue to flatten the curve. And I think the results are showing that that's happening. And I think once that proves to be a sustained pattern then you'll start to see some of the nonessential businesses allowed to be reopened back up and that will bring some certain relief to our customers and customers in our communities that have been shut down. And as a result the unemployment numbers are very high. There's no question about that. When you drive through town, parking lots are empty. So, you're going to have unemployment. But I think the measures will serve us well. The state will emerge from the crisis. The county will be reopened and businesses back to work and employees back to work.

All right. Perfect. Thanks for the comment. And then last one before I step back. So on the PPP program, $500 million of loans approved so far; looks like the average fee is about 2.8%. So just to make sure I have the math right here. That's roughly $14 million of origination fees that you expect to accrete into NII over whatever the life of the loans ends up being. Is that correct?

That is correct. We have about $1 million in direct origination costs that we will defer and net with those fees over the life of the loans as well.

Our next question will come from John Rodis with Janney. Please go ahead.

Good morning, guys.

Good morning.

Actually my question was just asked and answered on the average fee on the PPP loans. But obviously guys a lot of uncertainty and stuff. But Chuck, just curious and I get all the moving parts and stuff. But when you stress the loan portfolio, any thoughts on sort of cumulative losses over the next few years?

No, we've actually run several different models. Back in early 2017, we conducted a formal stress test of our loan portfolio using the stressed environment set by the Fed for the DFAST and CCAR testing that year. We felt confident about the results, which didn’t surprise us. Since the makeup and characteristics of the loan portfolio haven't changed much, we used the same inputs for our current portfolio. We believe this approach is sufficient without incurring the costs of redoing the process. Given the ongoing similarities in our portfolio, despite the growth, we anticipate an increase in provision expense across all three scenarios, significantly exceeding the expenses from the first quarter. These are unprecedented times, making it difficult to predict future conditions. Hopefully, the impact of this environment will be relatively short-lived. I won't repeat Bob's comments, but he has accurately assessed the duration of this crisis. It’s important to note that we are a commercial bank and the effects will vary among our commercial borrowers. Interestingly, some borrowers are performing well right now because they produce essential products during this time. Two of our larger watch list credits are among our best performers due to their industry. We could provide numbers all day, but we opted against CECL methodologies to remain as quantitative and logical as possible, given our loan portfolio's makeup. It's clear that the environment is stressful and companies and individuals will face challenges. An increase in past dues, non-accruals, and likely some charge-offs is expected, but the extent is uncertain. While we can run various scenarios, the unpredictability of this dynamic situation makes it impossible to accurately assess the impact on our bank or any other bank at this time.

No, you're right. It's difficult to determine what the new normal will be moving forward. Chuck, you mentioned that the margin, without specific guidance, is expected to decrease in the second quarter and then stabilize in the latter half of the year. Just to clarify, when you say it will be down in the second quarter, should we understand that as a decrease after accounting for the discount accretion? The core margin in the first quarter was approximately 3.42%, so you are indicating it will be lower than that in the second quarter?

Yes, you're right. My comments were indicating that we had a core margin of around 3.40% to 3.42%, and we anticipate a further decrease in the second quarter due to the FOMC rate cuts in early March, providing us a full quarter to reflect that. However, many of our prime-based loans, which comprise half of our floating rate loans, reached their floor rates at the beginning of March, meaning not every loan decreased by the full amount of the 150 basis points that the Fed reduced. Additionally, the 30-day LIBOR was at 99 basis points, and we are already seeing that LIBOR decrease this month, which aligns with our expectations based on market solidification. There are numerous factors at play, so I am hesitant to provide specific guidance. Nonetheless, I do expect a reduction in our core margin for the second quarter compared to the first, despite the PPP program. However, I foresee that our core margin will remain relatively stable for the remainder of the year once we have moved past any major changes in the indices supporting our loans.

Okay. Makes sense. Okay guys. Thank you and be safe.

Thank you.

Our next question comes from Damon DelMonte with KBW. Please go ahead.

Hey, good morning guys. How is it going today?

Hi Damon.

So, quick question for Ray. On the loan growth you saw this quarter in C&I, how much of that was attributable to increased line utilization? And what was the line utilization rate last quarter to this quarter?

Yes, this is Chuck. Regarding our loan growth, about half of it came from residential mortgage loans held for sale, while the other half was net loan growth on the commercial side. I want to clarify that we did see some increases in line balances towards the end of March, but it was not unusual. The level of change was typical for us. As a commercial bank, we have many lines of credit, so fluctuations of $5 million, $10 million, or $15 million on a daily basis are quite normal. While we did experience some gradual increases towards the end of the first quarter, it was consistent with what we usually see. Overall, our line utilization remains around 50%. Additionally, I want to emphasize that our line balances are supported by borrowing formulas. Customers are welcome to borrow against their lines of credit as long as they stay within these formulas. Any slowdown in their businesses due to the current environment may reduce the maximum amount they can borrow against existing lines. Again, there are many factors at play, but we have not observed any significant spike in line utilization overall. The $500 million in loan funding to PPP has certainly improved their cash flow situation.

Got it. Okay. And then just to circle back on the PPP. You may have mentioned this, and I might have missed it, but the $14 million in fees, you noted $1 million in expenses associated with that. Does that all come in when the loan is originated or is it spread out over the life of the loan? I may have missed that comment.

Yes, we are expected to receive the fee within five days of funding. I want to commend our team for their outstanding efforts over the last three weeks, where they've worked with over 1,500 borrowers to process applications and are now funding these loans. As of this morning or last night, our funding has reached $485 million, and we are nearing the completion of the initial wave. We are certainly optimistic that Congress will allocate more funds to the program, as we have additional customers waiting. While we may have passed the largest milestone, there are still borrowers seeking assistance, and we want to help them. We are discovering that, similar to our experience with the PPP program, we are encountering challenges in navigating the Federal Reserve's liquidity program. Everyone is trying to adapt to these new processes. This is not meant to criticize anyone; it's a new situation and we are figuring it out step by step. We’ve successfully managed the origination process, and now we are collaborating with banks and the Treasury to obtain these origination fees and determine the reporting requirements, as they are not aware of how much we have funded. They understand our requests and what borrowers have been approved for, but since the fees are tied to the timing of our funding, they lack this specific information. We are now tasked with creating a reporting system for them, which will enable them to begin processing the fees. Although they are supposed to pay us within five days of funding, this depends on us providing them with the necessary information on that day, which has led to some delays. Nonetheless, I believe we will be caught up in the next week or so regarding these funds.

Damon, this is Bob. I want to just pause for a second and follow up with something that Chuck said. I wanted to give our team here at Mercantile every one on our team's strong thank you and congratulations for being able to work through this PPP process, continuing to work through it. We had all hands on deck, you get people from all different areas of the bank regardless of what they did in their regular day job, helping with the process to make sure that we've got these applications in, processed, entered into the system, and approved by the SBA. And we wanted to include some of the comments in our deck just to reflect some of the feedback we have heard from customers that express appreciation for some of the things that they heard that were going on at other financial institutions where the process hadn't gone smoothly. And as Chuck said, this is a new process. We're all trying to work through it. But I give tremendous props to the Mercantile team for the work that they did making it as smooth of a process as we could for our clients through some very challenging times for everyone. And I want to just take a couple of seconds to say that because they really deserve it and I can't thank them all enough.

Okay. Great. This emphasizes the importance of community banks to the overall success of our banking system. Congratulations to your team. I have one more quick follow-up question regarding those fees. Chuck, when we consider these fees, how much of them were recognized in the first quarter? Or should we expect that the majority of the $14 million will be reflected in the second quarter?

Yes. The key question is when we expect the majority of our borrowers to request forgiveness after they have addressed their salary, mortgage, rent, and utility payments. We anticipate that many will reach this point towards the end of May and into June. Therefore, we believe that the bulk of the forgiveness will probably occur in the third quarter, with some continuing into the remainder of the year. The 1% financing may appeal to some borrowers, leading them to seek forgiveness later. While we assume that most will request forgiveness after they manage their cash flows for two months, it's challenging to predict their reactions. My analysis suggests that we expect the majority of requests to materialize in the third quarter, with a smaller portion in the fourth quarter.

Got it. Okay. That's all that I had. Thank you and stay safe out there.

Thank you, Damon.

Our next question comes from Brendan Nosal with Piper Sandler. Please go ahead.

Hey, guys. Just one follow-up for me. On slide 10, you lay out all of the COVID impacted industries. And obviously, it adds up to a decent chunk of kind of the total commercial loan balances. Which of these are seeing the most stress today? And which of these sectors kind of have you guys most concerned as this pandemic plays out over the next few months?

This is Ray. I would say that movie theaters are one key area that we're focused on. They're completely closed and effectively have no revenue. So that will be an area of focus. And restaurants are reduced to drive-thru only in some cases a complete closure in others. So that'll be another. And hotels, hotels lodging are significantly impacted by the inability to move around and travel for business and leisure. So I'd say those three are three key areas.

I will stress though, Brendan, that as we said earlier, over the years as part of our risk mitigation concentration processes, we look to partner with what we feel are very strong borrowers. And as we commented earlier, going into this crisis, most of our borrowers were in very solid financial condition and they had the ability to certainly weather the storm probably more so than many other tested clients you could bank in our communities. That said, Ray made some very good points though about businesses being dark right now. And that's why I think people in our state are working very hard to strike a balance between flattening the curve and reducing the virus, but also making sure that we're not excessively harming the economy more than we have to, to accomplish that. So, it's a balancing act, but those are all the - we're looking at our entire portfolio because there are some areas that probably the longer this thing goes on we'll have some surprises and some things that will have some unintended consequences from an economic and commercial standpoint, but we continue to monitor the whole portfolio. But we wanted to put this out there for the risk industry that we see are the biggest immediate impact industries of the closures so far.

Yeah, that all makes sense, and it's definitely helpful detail. Last one for me. Just looking at new retail payment assistance inquiries, looks like inquiries peaked around the end of March early April then came down. Is that just kind of timing due to when – what payments were due? Is that why that came down? And would you expect inquiries to increase again as we get to the end of April?

I think the way I would answer that – the way I would answer Brendan is that a lot of people that are either laid off or partially laid off or in some challenged income situation want to keep making their payments early and they will – as long as they can. And I think the inquiries at the start were say, hey, what are my options in case I need to go on a payment relief program? And so I think the longer this goes on certainly the more customers you'll have partaking in those pay relief opportunities. So, again, as we said, there are a lot of moving parts. A lot of it depends upon the depth of this crisis and the duration of the crisis. And so we've been very pleased with the performance of our clients so far. But certainly the longer it goes on, the more they'll be challenged and will also certainly partake more in these relief programs.

Yeah. Got it. All right. Thanks guys. Stay healthy.

Thank you.

This concludes our question-and-answer session. I would like to turn the conference back over to Bob Kaminski, President and CEO for any closing remarks.

Yeah. Thank you, Grant. And thank you all very much for your interest in our company and participating in the call today. We hope you and your families stay healthy and safe. This concludes the call.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.