Earnings Call Transcript - MBWM Q3 2022

Operator, Operator

Good morning, and welcome to the Mercantile Bank Corporation's Third Quarter 2022 Conference Call. All participants will be in a listen-only mode today. After today’s presentation, there will be an opportunity to ask questions. Please note that this event is being recorded. I would now like to turn the conference over to Julia Ward from Lambert Investor Relations. Please go ahead.

Julia Ward, Investor Relations

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 third quarter of 2022. Joining me today are members of Mercantile's management team, including Bob Kaminski, President and Chief Executive Officer; Chuck Christmas, Executive Vice President and Chief Financial Officer; and Ray Reitsma, Chief Operating Officer and President of the Bank. We will begin the call with management's prepared remarks and presentation to review the quarter's results then open the call to questions. Before turning the call over to management, 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 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 third quarter 2022 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 would like to turn the call over to Mercantile's President and Chief Executive Officer, Bob Kaminski.

Robert Kaminski, CEO

Thank you, Julia, and thanks to all of you for joining us on the conference call today. Today, our company released its September 30 financial results and we are pleased to report another very successful quarter with noteworthy results and several important performance metrics and strategic initiatives. Strong profitability driven by an increase in net interest margin trending to more normal levels from the lows over the past few years, continued growth in many of our fee income categories, continuation of steady loan growth in both commercial and retail portfolios with consistent strength in our loan pipelines, strong asset quality and diligent expense control. For the third quarter, Mercantile posted earnings of $1.01 per share and revenues of $49.6 million. Earnings per share for the first nine months of 2022 are $2.48. This morning, we also announced a cash dividend of $0.32 per share payable on December 14th. Ray and Chuck will provide the details on the various aspects of our performance for the quarter in their comments coming up shortly. As we have discussed during our communications over the past many quarters, the Mercantile team prides itself in nimbleness which allows us to skillfully adapt very quickly to various external forces and conditions. As we demonstrated throughout the pandemic, Mercantile management and employees were able to assess the conditions and then pivot to seamlessly transition to serve the needs of our clients and appropriately manage risks to ensure a strong performance of our company for our stakeholders. Now during the current environment, we and our clients and business partners are diligently working to continue positioning ourselves for optimal performance and results, should economic strains emerge as a result of the actions taken by the Fed to slow the high rate of inflation. Currently, however, the most common experience remains supply chain delays and disruptions in addition to mismatches in employment supply and demand. As of August 31, Michigan's unemployment rate fell 0.1% to 4.1%. Over the past 12 months, Michigan has added 135,000 payroll jobs and the unemployment rate fell by 1.9 percentage points from 6%. The largest employment gains have come from professional business services, manufacturing, leisure and hospitality and education and health services. Throughout 2022, the Mercantile strategic planning team has continued its focus on near-term tactics as we maneuver through this dynamic economic environment as well as our long-term vision and accompanying strategies for the future. We aim to enhance our sustainability as a high quality growth-oriented organization that can effectively craft and efficiently deliver best-in-class financial products and services to its clients. Our highly talented staff continually builds and develops relationships with clients and prospective clients with the resources and tools that our company provides. Data analytics help our team assess client needs who then craft strategies to meet those needs through the deployment of digital channels to assist in the delivery of products and services at the customers' convenience. Identification of Mercantile caliber talent to existing and new markets continues to be a strategic priority for our management team as we look to grow the company and create new opportunities. This people-first approach is an important aspect of how we grow our company organically as we seek to enhance our penetration in our mature markets as well as gaining a stronger foothold in our newer markets. Finally, I would like to thank the Mercantile team for their stellar efforts once again in the third quarter. Our company's performance has been strong in 2022, and I look forward to finishing the year with a solid fourth quarter which will position us well for a successful 2023 and beyond as we continue to build and enhance shareholder value. Those are my prepared remarks. I'll now turn the call over to Ray.

Raymond Reitsma, COO

Thank you, Bob. My comments will center around dynamics in the commercial and residential mortgage loan portfolios and non-interest income. We reported annualized core commercial loan growth of nearly 10% for the third quarter and 11% for the first-nine months of 2022. This growth has been possible due to the efforts of our commercial lending team and their focus on relationship building and the community bank value proposition and was achieved despite payouts related to asset sales or planned refinancing activities of $158 million year-to-date. Our commercial backlog remains consistent with prior periods as we continue to fund this impressive level of growth. The pipeline for construction commitments that we expect to fund over the next 12 months to 18 months totals $169 million. Presently, line of credit utilization is 36% compared to 33% a year ago, however, bank commitments in aggregate have increased $459 million over the past year. The portfolio is also well positioned for the rising rate environment as 64% of the portfolio is comprised of floating rate loans, up from 50% at March 31, 2021, accomplished largely through our SWOT program. Asset quality is pristine with non-performing assets of 2.8 basis points of total assets and nominal amounts of past due loans. There were no additions to non-accrual loans and non-performing assets during the quarter. While we are proud of our strong asset quality metrics, we remain vigilant in our monitoring efforts to identify any signs of deterioration in our loan portfolio. Our lenders are the first line of defense to recognize emerging areas of risk; our risk rating process is robust with an emphasis on current borrower cash flow in our rating model, providing sensitivity to any challenges evolving within borrowers' finances. All that said, our customers continue to report strong results to date and have not begun to experience impacts of a potential recessionary environment. We continue to closely monitor concentration limits within our portfolio. The mortgage business has slowed due to the rising rate environment and lack of available housing inventory in the markets we serve. Higher rates have led to more demand for adjustable rate mortgages, and the lack of inventory has led to more construction lending activity. We hold each of these types of loans on our balance sheet, and as a result, residential mortgages have increased 63% over the prior year. Compared to a gain on sale event, an immediate recognition of income, a portfolio alone takes about 24 months to generate an equal amount of income. We continue to pursue sharing the purchase market with originations in the third quarter, decreasing just 2% compared to the third quarter last year, despite the increase in mortgage rates since that time. Availability under residential construction loans has increased to $84 million this quarter compared to $54 million one year ago. Refinance activity is just 20% of last year's comparable quarter. Net interest income for the third quarter is down 53% compared to the third quarter of 2021. The primary contributor to the overall reduction was the previously described decrease in mortgage banking income of 73%, and a reduction in swap income of 86%, which more than offset the 19% increase in service charges on accounts, a 29% increase in payroll services income, and a 7% increase in credit and debit card income. The optimization of our branch network is an ongoing endeavor that has yielded seven-figure annualized savings, utilizing tools such as appointment banking, limited service branches, live ATM machines, and branch consolidations complemented by investments in our remaining facilities resulted in a nominal deposit attrition of less than 1% in the impacted markets. That concludes my comments; I will now turn the call over to Chuck.

Charles Christmas, CFO

Thanks, Ray, and good morning to everybody. As noted on Slide 10, this morning, we announced net income of $16.0 million or $1.01 per diluted share for the third quarter of 2022 compared with net income of $15.1 million or $0.95 per diluted share for the respective prior-year period. Net income during the first-nine months of 2022 totaled $39.3 million, or $2.48 per diluted share compared to $47.4 million, or $2.95 per diluted share during the first-nine months of 2021. Higher net interest income stemming from an improving net interest margin and ongoing strong loan growth combined with continued strength in asset quality metrics and increases in several key fee income revenue streams in large part mitigated a significant decline in mortgage banking revenue as industry-wide originations come off the record levels of 2020 and 2021, which were driven by low mortgage loan rates and resulted in refinance activity. Our earnings performance in the 2021 period also benefited from lower loan loss provisions, reflecting improved economic expectations. Turning to Slide 11, interest income on loans increased during the 2022 periods compared to the prior year periods, reflecting an increase in the interest rate environment and growth in core commercial and residential mortgage loans. Our third quarter loan yield was 59 basis points higher than the second quarter and 49 basis points higher than the third quarter of 2021. The yield on loans during the first-nine months of 2022 was relatively similar to that of the respective 2021 period as the increase in the interest rate environment impact didn't start in earnest until the second quarter of 2022, and the 2021 period was significantly impacted by PPP net loan fee accretion. Interest income on securities also increased during the 2022 periods compared to the prior year periods, reflecting growth in the securities portfolio to deploy a portion of the excess liquid funds position and the higher interest rate environment. Interest income on other earning assets, a vast majority of which is comprised of funds on deposit with the Federal Reserve Bank of Chicago, increased well during the 2022 periods compared to the prior year periods, generally reflecting the higher interest rate environment. In total, interest income was $12.2 million and $17.1 million higher during the third quarter and first-nine months of 2022 when compared to the respective time periods in 2021. We recorded a relatively small $0.1 million increase in interest expense on deposits during the third quarter of '22 compared to the third quarter of '21, in large part reflecting the recent increase in the interest rate environment. In comparing the first-nine months of 2022 to the respective time period in 2021, we recorded a $1.3 million decline in interest expense on deposits as lower deposit rates more than offset increased interest-bearing deposit balances. Interest expense on other borrowed money increased during the 2022 periods compared to the prior year periods, in large part reflecting interest costs associated with $90 million in subordinated notes issued between December of '21 and January of '22. In total, interest expense was $1.0 million and $1.1 million higher during the third quarter and first nine months of 2022 when compared to the respective time periods in 2021. Net interest income increased $11.3 million and $16.1 million during the third quarter and first-nine months of 2022, respectively compared to the respective time periods in 2021. We recorded a credit loss provision expense of $2.9 million and $3.5 million during the third quarter and first-nine months of 2022, respectively compared to a provision expense of $1.9 million during the third quarter of 2021 and negative provision expense of $0.9 million during the first-nine months of 2021. The provision expense recorded during the 2022 periods mainly reflected allocations necessitated by net commercial and residential mortgage loan growth, increased specific reserves on certain commercial loans and a higher reserve on residential mortgage loans stemming from a projected increased average life of the portfolio, which were not fully mitigated by the combined impact of a reduced COVID-19 environmental allocation, net loan recoveries, and continued strong asset quality metrics. The third quarter of 2022 provision level was also impacted by increased allocations associated with forecasted economic and business conditions. Continuing on Slide 13, overhead costs increased $0.5 million during the third quarter of 2022 compared to the third quarter of 2021 and were up $1.9 million during the first-nine months of 2022 when compared to the same time period in 2021. Excluding a second quarter $0.5 million contribution to the Mercantile Bank Foundation, overhead costs were relatively unchanged during the 2022 periods compared to the prior year periods; in large part, increases reflect higher compensation costs. Continuing on Slide 14, our net interest margin was 3.56% during the third quarter of 2022, up 68 basis points from the second quarter of 2022 and up 85 basis points from the third quarter of 2021. The improved net interest margin is primarily a reflection of increased yield on earning assets in large part reflecting the increase in interest rate environment thus far in 2022. As I noted earlier, we recorded increased interest income on loans during the 2022 periods compared to the 2021 periods, which was achieved despite a significant reduction in PPP loan fee accretion. During the first nine months of 2022, PPP net loan fee accretion totaled $1.1 million compared to $8.5 million during the same time period in 2021. Our average commercial loan rate increased 156 basis points during the first nine months of 2022, a significant increase on a loan portfolio that averaged about $3 billion during that time period. Our net interest margin continues to be negatively impacted by excess liquidity. However, as in the second quarter, the impact declined during the third quarter in large part to a lower volume of excess liquidity reflecting balances used to fund loan growth. The negative impact on our net interest margin from excess liquidity equaled 7 basis points during the third quarter of 2022 compared to 23 basis points during the second quarter of 2022 and 40 basis points during the first quarter of 2022. We expect the trend to continue to decline as excess monies continue to be used to fund future loan growth. Given the asset-sensitive nature of our balance sheet, which includes 64% of our commercial loan portfolio comprised of floating-rate loans, any further increases in short-term interest rates would have a positive impact on our net interest margin and net interest income. Our cost of funds has not increased meaningfully during 2022, increasing 4 basis points during the third quarter and 10 basis points during all of 2022 compared to the respective periods in 2021. Despite the increase in interest rate environment, our deposit rates and those of our competitors were not meaningfully raised through the end of the third quarter, which we believe reflects a relatively low level of competition for deposits, given the excess liquidity positions of most financial institutions. However, as interest rates continue to rise and excess liquidity positions decline, we believe deposit rate betas will ultimately return to historical levels. We remain in a strong and well-capitalized regulatory capital position. Our total risk-based capital ratio and all of our banks' regulatory capital ratios were augmented this past December and January with an aggregate $90 million issuance of subordinated notes, of which the vast majority of the funds were downstreamed to the bank as a capital injection. As of September 30, our banks' total risk-based capital ratio was 13.4% and was $150 million above the regulatory minimum threshold to be categorized as well capitalized. We did not repurchase shares during the first-nine months of 2022. We have $6.8 million available in our current repurchase plan. On Slide number 18, we share our latest assumptions on the interest rate environment and key performance metrics for the remainder of 2022 with the caveat that market conditions remain volatile, making forecasting difficult. We are forecasting continued net interest margin expansion due to loan growth and the interest rate environment during the fourth quarter with fee income, overhead costs and our tax rate to remain relatively consistent to that of the third quarter. This forecast is predicated on several expected additional increases in the federal funds rate, including a 75 basis point increase in early November and a 50 basis point increase in mid-December. In closing, we are pleased with our operating results and financial conditions through the first-nine months of 2022 and believe we remain well positioned to continue to successfully navigate through the myriad of challenges faced by all of us. Those are my prepared remarks; I'll now turn the call back over to Bob.

Robert Kaminski, CEO

Thank you, Chuck. That concludes management's prepared comments, and we'll now open the call up to the question-and-answer session.

Operator, Operator

We will now begin the question-and-answer session. Our first question will come from Brendan Nosal with Piper Sandler. Please go ahead.

Brendan Nosal, Analyst

Hey. Good morning, guys. How are you?

Robert Kaminski, CEO

Good morning, Brendan.

Charles Christmas, CFO

Good morning.

Brendan Nosal, Analyst

Good. Maybe to start off here on the near-term margin outlook. I guess, just digging a little bit more, it looks like Fed funds will likely increase by a similar amount in the 4Q versus the 3Q at least on a quarterly average basis, but it looks like you're assuming a good bit less margin expansion in the fourth quarter versus the third quarter. So I guess, just to start off, what are the deposit pricing assumptions you're using in the fourth quarter for your margin guide? And then maybe just help us understand deposit pricing dynamics more broadly as we move through this rate environment?

Charles Christmas, CFO

Sure. This is Chuck. I'll attempt to address that. The cost of funds continues to be a significant uncertainty, much like you've been hearing from other banks. Alongside provision expenses, we're navigating a unique period marked by a sharp rise in interest rates. However, most banks haven't proportionately increased deposit rates. As mentioned earlier, this is likely due to the excess liquidity in the system. While we've witnessed strong loan growth by utilizing these funds, we anticipate that competition for deposits will intensify, particularly if banks continue to grow at this pace. I reiterate that we expect betas to return to historical levels, which for us ranges between 40% and 60% in relation to changes in the prime rate, depending on the type of deposit. Up until the beginning of October, we made minimal adjustments to our deposit rates throughout the year. There have been some exceptions for large clients, but our bank-wide deposit rates remained largely unchanged until early October. Our rate comparisons suggest that we've aligned with the competitive landscape of other banks in our markets. For forecasting purposes, we are projecting a 20 basis point rise in our cost of funds in the fourth quarter compared to the third quarter, where we only experienced a slight increase of about 10 basis points over the entire year. We believe this is just the start of what we can expect heading into 2023, with competition being a key factor influencing deposit rates. It's challenging to predict how this will unfold, but we do anticipate an increase in deposit rates. Fortunately, as discussed by Ray and myself, we possess an asset-sensitive balance sheet, with 64% of our loans, or nearly 90% of our assets, being floating rate. This allows us to benefit from further interest rate hikes on the yield side, and we will see how the cost of funds evolves. A common question we receive is when we expect our margin to peak. We believe this will occur in the quarter when the Fed ceases increasing interest rates. Deposit costs tend to lag, notably because of the CD product, but we anticipate that deposit rates will rise following the Fed's completion of their rate hikes.

Brendan Nosal, Analyst

Yeah. That's fantastic. Thank you, Chuck for all of those thoughts and that color. Perhaps one more from me, just turning to capital. So you folks have avoided the worst of the AOCI marks that others have experienced, so sitting on both strong regulatory capital and tangible common equity today versus I think a lot of the space. Maybe just update us on how you think about kind of putting that excess capital to work over the next couple of quarters or year or so whether it's the buyback, dividend organic growth or M&A, just kind of walk us through those various uses?

Charles Christmas, CFO

Yeah. I think, first and foremost, we want to use the capital to continue our growth. As Ray mentioned, our pipelines are really strong. We've got quite a bit of construction funding. Yes, that remains, so we're looking forward to some strong net commercial loan growth. With the markets the way they are, we think that we'll continue to see growth in the residential mortgage portfolio, maybe not quite as much as we saw through the summer given the typical seasonality that we have here in Michigan and the Midwest. But first and foremost, we want to use that excess capital to fund our loan growth as long as we can prudently underwrite understanding the changing economic environments that we're going to have to keep an eye on. Clearly, we think our stock, I think every CFO is going to tell you their stock is underpriced especially in today's environment. We have not bought back our stock this year and really it's again mostly because we want to use every dollar, if you will, to fund that loan growth. We want to make sure that we keep our cash dividend at a meaningful level as we have, but we also want to be somewhat defensive as well. Clearly, there is an expectation that the economy will slow, clearly that's what the Fed wants to happen and just how that plays out is a big unknown. So if we want to keep some dry powder there in the capital base just to weather any storm that may be coming our way. We're in excess capital position, we like to be there and we don't want to do things to our capital position that puts us in a more difficult position if the economy becomes more negative than what we all hope.

Robert Kaminski, CEO

This is Bob. I'll add to that, about 10 months ago now, we did our subordinated debt offering for the purpose of being able to support our pipelines and our growth which has continued to be extensive and that really hasn't changed. Obviously, the concern about the economy is one that makes us cover our strong capital position if we're headed into potentially rocky waters as far as economic conditions, but we feel really good about it, we're able to deploy our capital with our growth and continue on a very strong position.

Brendan Nosal, Analyst

Fantastic. Thank you once again.

Robert Kaminski, CEO

You're welcome, Brendan.

Operator, Operator

Our next question will come from Daniel Tamayo with Raymond James. Please go ahead.

Daniel Tamayo, Analyst

Good morning, guys.

Robert Kaminski, CEO

Good morning.

Charles Christmas, CFO

Hi.

Daniel Tamayo, Analyst

Just I guess more on the deposit side, loan to deposit ratio is back up over 100%. I know you guys are comfortable on that level, but if you don't mind just reminding us where you're comfortable kind of taking that up to, I guess, I'll leave it there and then I'll follow up. Thanks.

Charles Christmas, CFO

Yeah, Daniel. This is Chuck. I'll take that one. Historically, we've been comfortable around 100% to 105%. One aspect we include internally is our suite product, which consists of repurchase agreements that average about $200 million. To us, this is deposit money linked to our strong relationships, and it factors into those agreements. This adjustment brings the ratio down to around 95%. We acknowledge that the loan to deposit ratio is higher than usual, but it reflects the lending opportunities we have and how we plan to fund that potential growth. We utilize our Federal Home Loan Bank advances in a significant manner, not just to support the asset side of our balance sheet but also to manage our long-term interest rate risk, particularly with our five-year fixed commercial real estate portfolio. Over the past couple of years, we’ve been actively engaged in our back-to-back SWOT program. The income generated from this initiative has been noticeable, but its main goal is to eliminate those five to seven-year fixed rate commercial real estate loans and transition them to floating rate loans. This shift means we don't need to rely on FHLB advances to handle long-term interest rate risks, giving us more flexibility on the deposit side. So, there are many factors at play here. In short, we're comfortable with a loan to deposit ratio of 100% to 105%, and that's what we aim to maintain.

Daniel Tamayo, Analyst

That's a great answer. I appreciate it. Regarding the credit side, the numbers are quite strong for the quarter. Can we discuss which categories you're keeping an eye on? It seems that in the slide deck, there's not much in terms of early indicators, yet we could be heading into a recession. Which loan categories are you monitoring most closely? Thanks.

Raymond Reitsma, COO

This is Ray. It's almost reflex to answer that with hotels and restaurants that's been the answer for a long time. They are showing any signs of stress at the moment as you implied in your question. As a matter of fact, the hotels that we financed have actually done quite nicely, but as the economy and the consumption economy moves from goods to services, the manufacturing portfolio is something that we're watching closely as they adjust to that. So far so good there. Also the impact of disruptions would be felt there first in the supply chain and the availability of goods and the like inputs. And then, finally, the dynamics around the markets that have office buildings in them are highly individualized, but we are watching those closely and we believe we have the right sponsorship groups there to withstand the changes that are coming there as firms come back to work or don't. And so, those are the primary areas that we're watching and again, no over signs of stress as you've noted from the stats, but nevertheless watching them very closely.

Daniel Tamayo, Analyst

Okay. Thanks, Ray. And then lastly, just relatedly on the reserve build small reserve build this quarter, you mentioned there is still a COVID factor in there. Just thoughts on what would be the biggest drivers, I think last quarter you talked about unemployment, you mentioned in your comments that Michigan unemployment went down again this quarter, but just thinking about what might be the impetus for reserves to build going forward? Thanks.

Charles Christmas, CFO

Yeah, Daniel. It's Chuck, again. As we look through our models, when I talk to other banks and they're dealing with their forecast and their models. It appears that and it makes sense that the unemployment rate is by far the biggest factor when it comes to overall economic growth or lack thereof. Clearly, if people are working, they have money in disposable income. If they're not working then the vast majority, if not all, their money goes to just making ends meet. So we're in a very strange environment, that the unemployment rate has stayed very, very steady at a very, very low level, which of course is causing all kinds of issues including wage inflation and difficulty, not only for the banking industry but all industries finding other talent and the people that they need. So I think it's really that unemployment factor that we continue to look at; I think that looking at our CECL solution that is one of the primary drivers. We did see a little bit of an uptick in the unemployment rate in our forecast that we use, a couple of forecasts that we use. And we also saw some slowdown in the GDP, which would make sense. So I think that was the impetus of the increase in our reserve through provision expense in the third quarter, which was about $1 million of the $2.9 million, almost $3 million that we provided, so about a third of our provision was related to just the forecast in the economic conditions that are there. I think that we will obviously continue to keep a look at, on the economy or we continue to use our forecast for our policy and for accounting guidance but we do have in our back pocket. We understand that we are more localized in the State of Michigan, although, obviously our industries are impacted globally, but we'll look at the economic forecast, which is for the country, but we will continue to look at kind of per Ray's comments, we'll continue to look at our portfolio, our markets to see how they're performing relative to the national forecast and if we see more of a protracted slowdown in our numbers and our expectations. We can certainly add to the reserve. In addition to whatever the actual forecast is providing for.

Daniel Tamayo, Analyst

All right. Thanks. I appreciate all the color. That's all from me.

Charles Christmas, CFO

You're welcome.

Robert Kaminski, CEO

Thanks, Dan.

Operator, Operator

Our next question will come from Eric Zwick with Hovde. Please go ahead.

Eric Zwick, Analyst

Good morning, guys.

Robert Kaminski, CEO

Hey, Eric.

Charles Christmas, CFO

Good morning.

Eric Zwick, Analyst

First, just wanted to start, I guess with the question on the commercial loan pipeline, if you could quantify that balance at the end of September and how that compares to the June 30 balance? And then also if you're able to provide any commentary into the specific geographies or industries that are maybe contributing more to that strength in growth?

Charles Christmas, CFO

Yeah. This is Chuck. I can do it from a number standpoint, but I'll let Ray give more color on more of the specific numbers. But when we look at putting our Q together and we've got to disclose our commitments to make loans, which is basically any bottom side commitment that we have made that has not been closed yet, we have actually seen quite a bit of an increase from where we were in June. I think in June, it was about $210 million, $220 million that we reported in our June 30 Q, as of June 30. We're looking at a number that's just a little bit over $300 million at September. Now clearly, there's negotiations going on there; some of those credits are being competed with other banks. We certainly don't expect to get all of them, but history does show us that we get a large majority of those. And then we would expect those to fund over the next 12 months to 24 months, clearly there are some construction loans in there. But from a numerical standpoint, the different ways that you can measure a pipeline continues to be very strong as we said and really for the comparable where we were at the end of last quarter has actually grown.

Raymond Reitsma, COO

Multifamily housing is currently in high demand for loans. Kent County recently released a study indicating a need for approximately 9,000 housing units over the next few years, while the delivery pipeline is only about 2,000 to 3,000 units. This creates a perceived shortage that developers are actively addressing, and we are monitoring this closely. Additionally, the general commercial and industrial sector is thriving in various forms. Our long-term relationship building in this area is yielding positive results and cannot be easily categorized by industry, but it encapsulates the overall trend effectively.

Eric Zwick, Analyst

That's helpful. I appreciate that. Maybe one quick follow-up on that, the C&I bucket, if you could remind me where the C&I utilization rate is today and then how that compares to what you would consider a more normal level?

Raymond Reitsma, COO

It was 36% compared to 33% the prior quarter. And I think normal is maybe high 30%’s and so we're just a little bit under. I think that reflects some request by our customers; they have more credit availability as they watch the prices of their inputs move skyward. And so, I think our customers and us together are positioned to deal with their needs in a fairly immediate future, say, over the next six months to a year.

Eric Zwick, Analyst

Thanks, I appreciate the follow-up there. And then moving to Slide 18 and your thoughts for some of the performance metrics in 4Q. Just looking at your expectation for average earning assets, it would seem to indicate relative to 3Q that they'd be flat to down a little bit. It sounds like loans will be strong and likely growing, so just curious about the offsets there, if it's cash, liquidity or maybe securities portfolio, just how you get to that number?

Charles Christmas, CFO

We are projecting a continuation of our trend this year, utilizing excess liquidity, mainly from the funds we have on deposit at the Fed, to enhance our loan portfolios, specifically in commercial and residential sectors. Overall, we are reallocating funds among our assets with little expected change on the liability side. We anticipate around 10% growth, and we believe our available funds at the Fed will support that without requiring significant deposit increases. However, I want to emphasize that we are always actively seeking deposits, and we have seen a positive influx of new deposits into the bank this year, aside from one deposit relationship we previously mentioned. Overall, deposits have remained relatively stable, although we have noticed some of our depositors and borrowers utilizing funds they had deposited earlier this year. On a positive note, we've experienced solid deposit growth, particularly with our C&I customers who bring in substantial deposits. Some of our deposit-only customers have also shown increases in their deposits. While we have sufficient funds at the Fed to support loan growth as we have in past quarters, we are fully committed to seeking opportunities to attract new deposit relationships and strengthen existing ones at the bank.

Robert Kaminski, CEO

Yeah. It underscores the point that Ray made about the volume, the C&I type of relationships that are in the pipeline right now and that we'll continue to call on because those are the relationships that tend to bring over the larger deposit accounts and will help partially fund that growth that we are doing in the pipeline.

Raymond Reitsma, COO

It's also worth noting that those accounts tend to be non-interest bearing and our commercial concentration leads to probably a greater than normal proportion that are non-interest bearing deposits on our balance sheet.

Charles Christmas, CFO

Yeah. And if I could add, that's a great comment that Ray just made, and I should have mentioned that when we were talking about the cost of funds earlier, having about 40% or so of your funds be in non-interest bearing clearly pays dividends in an environment that we're in today. And again, all those deposit, those C&I relationships, not only do you get the deposits, but then that of course goes into our ability to provide other treasury management products and services as well, which we've talked about have shown some strong growth and I think that strong growth in those categories not only reflects the opportunities we have in our existing deposit base and borrowing base, but reflects the success we have in cross-selling those products when we do bring in new C&I customers to the bank. So yeah, the C&I customers pay dividends in many different ways throughout the income statement.

Eric Zwick, Analyst

Thanks. I appreciate the complete answer there. One last topic from me, just curious about the specific reserve for the distressed commercial loan relationship. And just curious, is this a new situation or something you've been monitoring for a while and maybe could provide any color on today business or our industry and then what changed in 3Q to prompt the specific reserve?

Charles Christmas, CFO

This is a commercial and industrial relationship that came to our attention earlier this year, and we have been actively working on it. In any distressed situation, we collaborate with the borrower and their management team to identify the issues and implement corrective measures. The loan is classified as a performing troubled debt restructuring, meaning the company remains operational and viable, but it has met the guidance criteria for troubled debt restructuring for us. From an accounting standpoint, we have to consider it similarly to a non-accrual loan. Consequently, we conduct substantial discounting on valuations when assessing our collateral, and we recognize the need for a significant specific reserve for this credit. However, I want to emphasize that it is a performing troubled debt restructuring and not a non-accrual account, so the related rules will eventually disappear. A year from now, we would likely not be facing a large specific reserve if those rules were not in place. Nevertheless, we continue to maintain a reserve for this credit as we work with the borrower to improve their situation and explore options to reduce our exposure.

Eric Zwick, Analyst

Got it. Maybe just one quick follow-up there. Go ahead.

Charles Christmas, CFO

Yeah. From a relationship standpoint, it's a one-off as far as the overall credit situation with that borrower compared to the rest of our volume.

Eric Zwick, Analyst

Thanks. My follow-up was going to be about whether this is a specific issue related to the company or if it’s connected to broader industry pressures, supply chain issues, or other factors we are all monitoring.

Robert Kaminski, CEO

I will say that, I guess my reaction to that, it shows you the overall strong quality of the portfolio, if we're talking about one change in a loan grade reserve that is a purely one-off situation. So I appreciate the question about it, but it's not reflective of a trend that we're seeing; it's a one-off situation that there is a plan in place to make sure that situation gets corrected.

Eric Zwick, Analyst

Understood. That's great to hear. Thanks for taking my questions today.

Robert Kaminski, CEO

You're welcome.

Charles Christmas, CFO

You bet.

Operator, Operator

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

Damon DelMonte, Analyst

Hey. Good morning, guys. Hope everyone is doing well today? I appreciate all the color and insight on the loan pipelines and the outlook there. Just kind of wondering are your commercial developers kind of pulling back at all or hesitating given the rapid rise in rates, and especially, if we see like another 125 basis points of increase by year-end, do you think that's going to weigh on sentiment at all?

Raymond Reitsma, COO

I think it depends on the product, so do you have one in particular in mind?

Damon DelMonte, Analyst

Just commercial real estate development. If you're planning out the budget process for a project and all of a sudden rates are going up a lot faster than maybe they thought, does that give them pause to put a project on hold?

Raymond Reitsma, COO

I mean, obviously, that all goes into the calculus of a project and where that will create a slowdown is where the rents are less robust and not on upward trend. In multifamily, they certainly are on an upward trend and so the rates and the income have moved fairly well in parallel with some tightening, but that's reaching I think a climax where we're getting to a point where much more increase in long-term rates will begin to have a dampening effect. We've seen a lot less demand; actually, a notable lack of demand in product types like retail or office buildings. And as a result, the activity is very minimal there, only for the strongest sponsors or maybe somebody who has an existing low leverage project. So that's what the landscape looks like for us at the moment.

Damon DelMonte, Analyst

That's great. I appreciate that information. Regarding expenses, the guidance for the fourth quarter shows that the midpoint of your range is relatively flat compared to your current position. What strategies do you have available to address the inflationary pressures we are experiencing?

Charles Christmas, CFO

I wish I had more options than I currently do. However, when you examine a bank's income statement, it's clear that compensation and benefit costs are significant factors. Like everyone else, we're facing a lot of inflation. We must ensure our employees are compensated competitively in the market and do our best to mitigate the effects of inflation on them. This all contributes to a situation where we will continue to see strong inflation affecting our salary, compensation, and benefit costs. We'll take necessary measures as we always have and will explore other areas of the income statement, such as margin management, provision expense, and fee income, to help alleviate the pressure from overhead costs.

Robert Kaminski, CEO

Damon, Ray can back me up on more specific cost hurdles, but branch optimization project that we've been forecasting over the last several years, we've been able to consolidate or close a number of branches that have helped bring those expenses rates in the bottom line in terms of savings. So while there may not be a plethora of levers where we're looking at every requirement that we can to make sure that we're as efficiently run as we can be, but at the same time, making sure that we take care of our employees who enable us to do the things that we were able to do.

Damon DelMonte, Analyst

Got it. Okay. And then I guess just lastly on the fee income side, do you feel like the mortgage banking income has kind of leveled at this point or has it reached the bottom or do you think that there is still more downward pressure on that line item?

Charles Christmas, CFO

I believe that overall, we feel we have reached a bottom in our production numbers. Clearly, we experience seasonality, especially since most of our product comes from home sales rather than refinances. This makes us vulnerable to seasonal changes, and, as you know, there isn't much buying and selling of homes in January and February. Therefore, we expect some typical seasonal fluctuations, but overall, it seems we have reached a certain level of bottom.

Damon DelMonte, Analyst

Got it. Okay. That's all I had. Thanks a lot. Appreciate all the color.

Robert Kaminski, CEO

Thanks, Damon.

Operator, Operator

This concludes our question-and-answer session. I'd like to turn the conference back over to Bob Kaminski for any closing remarks.

Robert Kaminski, CEO

Yes. Thank you very much for your interest in our company, and we look forward to speaking with you next at the end of the fourth quarter. This call has now concluded.

Operator, Operator

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