Earnings Call Transcript
MERCANTILE BANK CORP (MBWM)
Earnings Call Transcript - MBWM Q2 2023
Operator, Operator
Good morning, and welcome to the Mercantile Bank Corporation Second Quarter 2023 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 like now to turn the conference over to Zack Mukewa, Lambert Investor Relations. Please go ahead.
Zack Mukewa, 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 second quarter. 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's 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 press release and presentation deck issued by Mercantile today, you can access it at the company's website at 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 Kaminski, CEO
Thank you, Zack, and thanks to all of you for joining us on our conference call today. Mercantile released its June 30 financial results this morning, which built on the successful first quarter and reflects the overall strength and excellence of our company as we reach the mid-year point of 2023. During the quarter, Mercantile produced earnings of $1.27 per share and revenues of $55.2 million. For the six months ended June 30, Mercantile earned $2.58 per share on revenues of $110.5 million. This morning, we also announced a cash dividend of $0.34 per share payable on September 13, 2023. Highlights for the quarter include continuation of excellent asset quality, steady levels of core deposits, solid loan growth despite some sizable payoffs, pipelines continuing strong, strong net interest margin, robust capital levels, solid liquidity, and well managed overhead expenses. We are pleased with the continuation of these solid fundamentals that are made possible by the excellent work of the Mercantile team and also demonstrate the strength of our client base with whom Mercantile engages. During the second quarter, Mercantile generated net annualized commercial loan growth of 6%, as new funding volumes weighted more heavily toward the latter part of the quarter in June outpaced loan payoffs which had been meaningful over the last several quarters. Despite continued strength in ongoing loan fundings, the aggregate pipeline of commercial loans in all of our markets remains at a very high level. Customers generally report solid sales opportunities, although occasional challenges remain in the marketplace, along with concerns about the threat of a recession in view of the continued tight need of interest rates. The overall strength of our asset quality remains an important aspect of our financial performance; past dues, non-performing loans, charge offs and other real estate owned all remain at peer-leading levels. As we've discussed on previous calls, Mercantile's lending administration monitors loan concentrations very closely to ensure that we do not get over weighted in loan types or industries. Our team remains highly engaged with our clients to identify potential problem loans at the earliest signs of distress and works collaboratively with clients to ensure that the issues are corrected and the risks to the bank are minimized. Ray and Chuck will provide more details on our financial performance shortly. The Mercantile brand of relationship-focused banking clearly resonates with clients and potential clients and the communities we serve. When customers need meaningful financial advice and counsel, the Mercantile banker is there to work with them. Our team members fill the role of trusted advisors, offering feedback as only Mercantile bankers can because we know their businesses. This is especially important during uncertain times, and we've had a lot of uncertainties over the last several years. This is the value-added facet of banking with Mercantile. We live and work in the same communities that they do, which allows for efficient local decision-making. Understanding customers' and communities' needs is one of the most important responsibilities of financial institutions, and that has been a focus for Mercantile since our founding. In that regard, in the second quarter, Mercantile announced the formation of Mercantile Community Partners, a wholly-owned subsidiary of Mercantile Bank that will offer debt financing and direct equity investments for affordable housing and rehabilitation projects. Mercantile Community Partners will work directly with developers as they plan multi-family projects across the state, providing a one-stop shop for financing and support for securing state tax credits. Regarding the Michigan economy, we would still characterize it as steady with unemployment coming in at 3.7% at the end of May compared to 4.3% as of December 31, 2022, and 4.0% in May of 2022. Most businesses in our markets are still seeking to hire staff reinforcing the relatively low unemployment numbers. As has been well documented, actions taken by the Fed to slow inflation continue to increase the cost of borrowing by businesses and consumers and raise concerns of a possible recession. As we have demonstrated in the past and most recently during the pandemic, challenges experienced during the pandemic, we believe Mercantile is well-positioned to successfully manage through a variety of conditions, effectively serve our clients and our communities and create value for our shareholders. Those are my prepared remarks. I'll now pass the microphone over to Ray and then to Chuck.
Ray Reitsma, COO
Thanks, Bob. My comments will focus upon commercial loan growth, net interest margin and income, asset quality, non-interest income, and core deposit growth. Commercial loan growth was strong this quarter, increasing $48 million or 6% annualized despite $108 million in reductions, primarily due to borrowers refinancing in the secondary market and application of excess cash flow to debt balances. Commercial growth in the second quarter occurred entirely within the C&I segments, while CRE segments have been essentially level as projects have been paused to evaluate the impact of demand dynamics and higher interest rates. The commercial pipeline has grown sequentially over the last five quarters to an all-time high of $678 million consisting of $327 million committed to under construction loan facilities and $351 million under other commercial loan commitments. Residential mortgages grew $38 million, and the pipeline of funding commitments related to this type of asset remains stable at $59 million. Net interest income benefited from the growth described above as well as from an increase in earning assets yields from 5.9% in the prior quarter to 6.19% in the current quarter. The portfolio is well positioned for any change in the interest rate environment as 65% of the portfolio consists of floating rate obligations compared to 50% five quarters ago, accomplished through disciplined application of our swap program coupled with a fixed rate deposit portfolio that correlates in size and duration to our fixed rate loan portfolio. Asset quality remains pristine and improved during the quarter as non-performing assets totaled $2.8 million, or 5 basis points of total loans at the end of the current quarter compared to $8.4 million or 20 basis points of total loans at the end of the prior linked quarter. The majority of this reduction was achieved through the payoff of our largest non-accrual borrower by an asset-based lender. We remain vigilant in our underwriting standards and monitoring to identify any deterioration within the portfolio. Our lenders are the first line of observation and defense to recognize areas of emerging risk. Our risk rating model is robust with continued emphasis on current borrower cash flow providing prompt sensitivity to any emerging challenges within a borrower's finances. That said, our customers continue to report strong results to date and have not begun to experience the impacts of a potential recessionary environment. Total non-interest income is nearly level with the comparable quarter in 2022. Service charges on accounts and mortgage banking income have both been negatively impacted by the general increase in interest rates. Service charges have reduced 29% relative to the comparable prior year quarter due to an increase in the earnings credit rate, and mortgage income has declined 6% to the comparable prior year quarter due to reduced housing inventory for sale in the markets that we serve and the general effect of higher interest rates. Despite a reduction of 39% in the total amount of mortgage loans originated, total saleable mortgage loans are down only 3%, and income on the sale of mortgage loans is down only 10%. This reflects efforts to reduce portfolio mortgage loans and increase saleable loans to decrease the related funding burden and interest rate risk on the balance sheet. Offsetting these declines were positive performance in credit and debit card income, which grew 14% compared to the prior year period, interest rate swap income which grew 74% compared to the prior year period, and payroll income, which grew 23% compared to the prior year period. Deposit balances have been very steady in our retail portfolio over the last six months. Business deposits typically follow a seasonal pattern where commercial deposits contract in the first quarter as clients pay bonuses and taxes and then build during the remainder of the year. This pattern occurred in 2023 as business deposits decreased by $124 million in the first quarter followed by a $150 million increase in the second quarter. These core deposits were supplemented with FHLB advances and brokered deposits to fund the strong commercial and mortgage growth described earlier in my remarks. We continue to pursue a number of strategic initiatives around the deposit generating opportunities that exist within portions of our customer base and the markets that we serve. That concludes my comments. I will now turn the call over to Chuck.
Chuck Christmas, CFO
Thanks, Ray, and good morning, everybody. As noted on Slide 10, this morning, we announced net income of $20.4 million or $1.27 per diluted share for the second quarter of 2023 compared with net income of $11.7 million or $0.74 per diluted share for the respective prior year period. Net income during the first six months of 2023 totaled $41.3 million or $2.58 per diluted share compared to $23.2 million or $1.47 per diluted share during the first six months of 2022. The improved operating results were in large part driven by higher net interest income, stemming from an improving net interest margin and ongoing loan growth, and continued strength in loan quality metrics providing for limited provision expense. Turning to Slide 11. Interest income on loans increased during the second quarter and first six months of 2023 compared to the prior year periods, reflecting the increase in interest rate environment and solid growth in commercial and residential mortgage loans. Our second quarter net interest margin was 117 basis points higher than the second quarter of 2022, and our net interest margin for the first six months of 2023 was 143 basis points higher than the respective prior year period. The improved net interest margin primarily reflects the combined impact of an aggregate 500 basis point increase in the federal funds rate since March of 2022 and approximately two-thirds of our commercial loans have been floating rate. Interest income on securities also increased during the 2023 periods compared to the prior year periods, reflecting growth in the securities portfolio and the higher interest rate environment. Interest income on other earning assets, a vast majority of which is comprised of funds on deposits with the Federal Reserve Bank of Chicago, declined by about $0.2 million in both the second quarter of 2023 and the first six months of 2023 compared to the prior respective periods. While their rate paid on by the FRB of Chicago has increased substantially since March of 2022, our average deposit balance was considerably lower. In total, interest income was $26.4 million and $51 million higher during the second quarter and first six months of 2023 respectively when compared to the prior year periods. We recorded increased interest expense on deposits in our sweep account product during the second quarter and first six months of 2023 compared to the prior year periods, reflecting the increase in the interest rate environment, transfer of deposits from no or low-costing deposit products to higher costing deposit products and enhanced competition for deposits. Interest expense on Federal Home Bank of Indianapolis advances also increased during the 2023 periods compared to the prior year periods, reflecting growth in the advanced portfolio and the higher interest rate environment. Interest expense and other borrowed money increased during the 2023 periods compared to the prior year periods, reflecting the higher interest costs of our trust preferred securities. In total, interest expense was $13.1 million and $20.2 million higher during the second quarter and first six months of 2023 respectively when compared to the prior year periods. Net interest income increased $13.2 million and $30.7 million during the second quarter and first six months of 2023 respectively compared to the prior year periods. We recorded a provision expense of $2.0 million and $2.6 million during the second quarter and first six months of 2023 respectively, mainly reflecting adjustments to historical baseline loss allocations to better represent our expectations for future credit losses. Changes to qualitative factors were limited to a reduction of the historical loss information factor which coincided with adjustments to historical baseline loss allocations and the elimination of certain specific reserve allocations. Reserve allocations associated with net loan growth during both 2023 periods were largely mitigated by lower reserve allocations stemming from modestly improved updated economic forecasts. Continuing on Slide 13, we recorded increased overhead costs during the second quarter and first six months of 2023 compared to the prior year periods. Overhead costs increased to $0.9 million during the second quarter of 2023 compared to the second quarter of 2022 and were up $3.7 million during the first six months of 2023 when compared to the same period in 2022. The increased overhead costs primarily resulted from larger compensation costs, increased reserve allocations for unfunded loan commitment and higher interest rate swap collateral holding costs. Continuing on Slide 14, our net interest margin was 4.05% during the second quarter of 2023, up 117 basis points from the second quarter of 2022, and was 4.16% during the first six months of 2023, up 143 basis points from the first six months of 2022. The improved net interest margin is primarily a reflection of an increased yield on earning assets, in large part reflecting the increasing interest rate environment over the past 12 months. Our loan yields have increased 22 basis points over the past 12 months, primarily reflecting the combination of increase in interest rate environment and approximately two-thirds of our commercial loans having floating rates. Our average commercial loan rate has increased 255 basis points over the past 12 months, a significant increase on our loan portfolio that averaged about $3.1 billion during that time period. After increasing only about 3 basis points per quarter over the first three quarters of 2022, our cost of funds increased 17 basis points during the fourth quarter of 2022; 42 basis points during the first quarter of 2023; and 49 basis points during the second quarter of 2023. Despite the increase in the interest rate environment that started in earnest during the first quarter of 2022, our deposit rates and those of our competitors were not meaningfully raised during the first nine months of 2022, which we believe reflected a relatively low level of competition for deposits given the excess liquidity position at most financial institutions. However, as interest rates continue to rise and excess liquidity positions declined, deposit rates have been increasing. In addition, we are also experiencing the transfer of deposits from no or low-cost deposit products to higher cost deposit products. We have included a couple of slides in our presentation to pick information on our investment portfolio, which are slides number 20 and 21. There were only nominal changes to our investment portfolio during the second quarter of 2023, largely limited to ordinary purchases and maturities of municipal bonds. All of our investments remained categorized as available for sale. As of June 30, about 65% of our investment portfolio comprised of U.S. Government Agency bonds, with approximately 30% comprised of municipal bonds, all of which were issued by municipal entities within the state of Michigan and a high percentage within our market areas. Mortgage-backed securities, all of which are guaranteed by a U.S. Government Agency, comprised only 5% of the investment portfolio. The maturities of the U.S. Government Agency and Municipal Bond segments are generally structured on a laddered basis; a significant majority of the U.S. Government Agency bonds mature within the next seven years with over three-fourths of the municipal bonds maturing over the next 10 years. On Slide number 18, we did pick the unrealized gain and loss of the investment portfolio from the second quarter of 2021 to the second quarter of 2023. The net unrealized loss started to increase meaningfully during the third quarter of 2022. To date, the net unrealized loss peaked at $92 million as of September 30, 2022, and equaled $78 million as of June 30, 2023. The significant increase in the net unrealized loss reflects the increase in the interest rate environment. It is important to note that the same increase in the interest rate environment has had a substantial impact on our net interest margin leading to significant growth in net interest income and net income. Turning back to Slide 19, we have provided repricing data on our loan portfolio. About two-thirds of our commercial loans have a floating rate, while about 88% of our fixed-rate commercial loans mature within five years. Our retail loans are largely comprised of 7-1 and 10-1 adjustable rate mortgage loans with most subject to adjustment within the next seven years. In aggregate, approximately 83% of our loans are subject to repricing within the next five years. On Slide number 23, 24 and 25, we provide data on our deposit base. You will note that we include the sweep account in our deposit tables and calculations as those accounts reflect monies from entities, primarily municipalities that elect to place their funds in a sweep account that is fully secured by U.S. Government Agency bonds. Even with the seasonal decline we experienced during the first quarter of each year, non-interest bearing checking accounts comprised a significant 34% of total deposits and sweep accounts since June 30, 2023; a large portion of those funds are associated with commercial lending relationships, especially commercial and industrial companies. The level of uninsured deposits, which totaled 47% as of June 30, 2023, has remained relatively stable over many years. On Slide 24, we provide information on depositors with balances of $5 million or more. As of June 30, 2023, we had 70 relationships with aggregated $1.2 billion. About 83% of the relationships and approximately 86% of the total deposits were with businesses and/or individuals with the remaining comprised of municipal entities. Of those 70 relationships, 29 of those have had balances exceeding $5 million for at least five years. As a commercial bank, a majority of our deposits are comprised of commercial accounts. On Slide number 25, we depict our deposit balances as of the three past quarter ends. Excluding brokered CDs, business deposit accounts were up $39 million during the second quarter, following a decline of $124 million during the first quarter, that primarily reflected business customers' seasonal payments of taxes and bonuses and partnership distributions. Aggregate personal deposit totals have remained relatively unchanged during the first six months of 2023. During the first six months of 2023, we experienced transfers of funds from no and low-cost checking and savings deposits to higher paying money market and time deposits, a trend we expect to continue. On Slide number 26, we depict our primary sources of liquidity as of quarter end. We do periodically use our unsecured federal funds line of credit with a major correspondent bank; however, we have not utilized this line since late April. Our deposit balance at the Federal Reserve Bank of Chicago equaled $130 million as of June 30, 2023, compared to $6 million at the end of the first quarter. We obtained $111 million of broker deposits and $90 million in FHLB advances during the second quarter of 2023 combined with $70 million in FHLB advances during the first quarter of 2023 to offset the impact of loan funding and net deposit withdrawals during the first half of the year and to rebuild our on-balance sheet liquidity position. Our level of wholesale funds as a percentage of total funds was 13% as of June 30 compared to 7% at year-end ‘22. We remain in a strong and well-capitalized regulatory capital position. Our bank's total risk-based capital ratio was 13.7% as of June 30, 2023, about $177 million above the minimum threshold to be categorized as well capitalized. We did not repurchase shares during the first six months of 2023 and have $6.8 million available in our current repurchase plan. While net unrealized gains and losses in our investment portfolio are excluded from regulatory capital calculations, on Slide 22, we depict our Tier 1 leverage and total risk-based capital ratios, assuming the calculations did include that adjustment. While our regulatory capital ratios were negatively impacted by pro forma calculations, our capital position remains strong. As of June 30, 2023, our Tier 1 leverage capital ratio declines from 12.2% down to 10.9% and our total risk-based capital ratio declines from 13.7% down to 12.4%. Our excess capital, as measured by the total risk-based capital ratio is also negatively impacted. However, it totals a strong $115 million over the minimum regulatory minimum to be categorized as well capitalized. Finally, my thoughts on the remainder of 2023. On Slide 27, we share our latest assumptions on the interest rate environment and key performance metrics for the remainder of 2023 with the caveat that market conditions remain volatile making forecasting difficult. This forecast is predicated on the federal funds rate via an increase by 0.25% on July 26 and then staying unchanged for the remainder of the year. We are projecting total loan growth in the range of 5% to 6% for both commercial and residential mortgage loan portfolios. While we have experienced solid loan fundings throughout 2023 thus far and our commercial loan pipeline remains very strong, we continue to experience a high level of payoffs and paydowns. We are forecasting our net interest margin to decline by 15 basis points to 25 basis points during the third quarter from 4.05% we recorded during the second quarter and then 10 basis points to 15 basis points down during the fourth quarter of 2023 from expected range during the third quarter of the year. In closing, we remain very pleased with our operating results and financial condition through the midway point of 2023 and believe we remain well positioned to continue to successfully navigate through the myriad of challenges faced by all financial institutions. Those are my prepared remarks; I will now turn the call back to Bob.
Bob 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 comes from Brendan Nosal with Piper Sandler. Go ahead.
Brendan Nosal, Analyst
Hey. Good morning, guys. Hope you're doing well.
Bob Kaminski, CEO
All right.
Brendan Nosal, Analyst
Maybe just to start off on funding costs, hoping you could walk us through the evolution of funding cost pressures over the course of the quarter and then kind of thoughts on where that moves from here. And then if you happen to have it, we'd be curious to know what the spot margin was as of June 30.
Bob Kaminski, CEO
I don't have the current spot margin, but I can find that for you. The offered deposit rates have been consistently rising over most of the first six months. This is partly due to the increasing interest rate environment. Although the rates have not risen as much as they did in 2022, the Federal Reserve has been raising interest rates. As we noted, competition for deposits is quite intense right now. I expect that as long as the Fed continues to raise interest rates, we will feel pressure to increase deposit rates. This is particularly true for money market and time deposit products. Overall, deposit rates will likely follow the Fed's actions. Once the Fed stops raising rates, I believe our offering rates will remain relatively stable and high due to competition, but I do not anticipate any further increases in our operating rates after the Fed finishes its rate hikes.
Brendan Nosal, Analyst
All right. Great. That's helpful color. Maybe one more from me. Can you folks offer a little bit of color and maybe provide an update on the office portfolio. Just kind of walk us through the composition of that book, things like location, LTV, occupancy. Just any color you can offer?
Ray Reitsma, COO
Our office portfolio is predominantly in West Michigan, and they continue to be the projects that we fund have continued to be supported by strong sponsors and have not seen market change in occupancy. And so while it's a segment that we continue to scrutinize closely, have not seen as much change in it as you might expect, given the general headlines around the topic in the financial press.
Brendan Nosal, Analyst
All right, perfect. Thanks for taking the questions. Congrats on the quarter.
Bob Kaminski, CEO
Thank you.
Ray Reitsma, COO
Thank you.
Daniel Tamayo, Analyst
Good morning, guys. Thanks for taking my question.
Bob Kaminski, CEO
Good morning, Dave.
Daniel Tamayo, Analyst
I guess first the non-interest bearing number really, really didn't move a whole lot during the quarter. And I think I was expecting as well as a lot in the industry for that to come down a bit. Did that surprise you and maybe if you could just talk about the timing during the quarter, if there was a slowing of migration or just anything that might help us figure out what's happening in the non-interest bearing?
Chuck Christmas, CFO
Sure, Daniel. This is Chuck. We often discuss the seasonal withdrawals of non-interest bearing deposits from our business customers, particularly in January, with some in December as well. We anticipate a reversal of that trend as we move into the second quarter and experience this seasonality again. Next January, we expect another decline, but we foresee positive balances improving from January of this year to January of next year. In the second quarter, we observed some stabilization due to our strong loan portfolio supported by capable operators. Tax payments in April were also slightly higher than usual. Since those payments in mid-April, we've seen consistent growth in non-interest bearing checking accounts, which we expect to continue throughout the year as balances accumulate for payments next January. However, I don’t foresee non-interest bearing deposit balances returning to last year's levels, as we are witnessing a transfer of funds from those accounts to mainly business money market accounts. Previously, with low rates, businesses didn’t feel the need to move money between account types, but that perspective has shifted over the past 12 to 18 months, leading to tempered growth in non-interest bearing accounts for the remainder of the year. Nevertheless, we do expect some growth, as well as growth in our money market business accounts.
Daniel Tamayo, Analyst
That's very helpful. Thank you, Chuck. I'm curious about your thoughts on the composition of your clientele with non-interest bearing deposits. You mentioned anticipating some pressure and that some customers are moving to interest bearing accounts or requesting that option. Have you analyzed whether this trend is more prevalent among your largest clients as opposed to smaller ones? Additionally, have you gathered any insights regarding the sources of this pressure and how it might affect your outlook moving forward?
Bob Kaminski, CEO
Yeah, Danny. As you inferred, I think that it is correct that the larger the customer is the more likely they are to have that sensitivity to want to earn more on their deposit account. There are certain segments of our loan portfolio that do fund themselves with deposits that are greater than their loans and so we're trying to increase that piece of portfolio, so that the spillover if you will can help fund other parts of the portfolio, but in general, what you've said is correct.
Daniel Tamayo, Analyst
Do you have details on the average deposit size or the average client size? Is there a categorization you can share regarding what's already changed and what hasn't? This could help us understand what deposits may be more stable versus those that might be at risk of moving to interest-bearing accounts.
Bob Kaminski, CEO
That information exists. It's not something that would be great to share at this point. I'd hate to point our competitors right at our deposit-rich customers. But there are definitely segments that are more deposit-rich than others.
Daniel Tamayo, Analyst
Okay. Fair enough. And then I guess the last question. It seems that the guidance for the fourth quarter net interest margin has been raised slightly compared to last quarter. If that's accurate, was this increase solely due to the better than expected margin in the second quarter, or was there another primary factor driving this change?
Bob Kaminski, CEO
Yeah, Daniel. The driver of that's going to be the Fed increase we got in May that we didn't have budgeted. And then as I mentioned, we do expect to set the rates by 25 basis points next week as well. So there's really 225 basis point increases that we factored into our numbers this time around that we didn't have three months ago.
Daniel Tamayo, Analyst
Okay. If you extend that forecast, it would essentially remain unchanged as the rates are applied. There are many variables to consider, and I appreciate your insights.
Bob Kaminski, CEO
Talk to yourself out of it.
Daniel Tamayo, Analyst
Thanks for all the answers.
Bob Kaminski, CEO
You're welcome. Thanks, Danny.
Erik Zwick, Analyst
Good morning. Wanted to maybe kind of continue on Daniel’s last question in terms of the outlook for the rest of the year, but more focus on the loan outlook and just want to make sure I kind of understood the comments in your prepared remarks that bringing that guidance down from that 6% to 8% level to 5% to 6% level just given the strength in the pipeline. Is bringing that down really a reflection of the expecting kind of more pay downs in the back half of the year than expected or is there anything else in the market that you're sensing where you're choosing to be more conservative or just trying kind of balance all those thoughts?
Chuck Christmas, CFO
Yeah, Eric. It's a great question. And from a commercial side, we're really not changing our outlook. We're looking at 5% to 6% for the rest of this year annualized and that's pretty much what our expectation was three months ago. The difference is in mortgage lending. Ray kind of touched on what's going on in the competitive environment, the housing stock and obviously relatively high interest rates. Although we all know from historical standpoint, it's not that bad. And then Ray also touched on the fact that we're kind of changing our product mix around a little bit to try to be able to sell more of our loans, which basically more fixed-rate loans as a percent of the composition, what we're putting on the books is our ARM products, which I think as you know are very difficult to sell. And all banks are faced with that is the way that with the yield curve and the way mortgage rates have been working, a majority of borrowers, new borrowers have been taking the ARMs, which of course will be added to our balance sheet and putting more pressure on an already stressed funding structure. And so we've made a conscious effort within our residential mortgage function to take some steps to try to increase the percentage of the loans that we are making into the fixed-rate bucket so we can sell them. And then, of course, like I said, then you've got the external environmental factors of housing market, housing stock available and still some pretty relatively high interest rates slowing that segment down as well. So what you see in the decline what we talked about three months ago from today, we expect commercial loan growth really unchanged from what our thoughts were before. It's the mortgage loan expectations that are driving the overall percentage down.
Erik Zwick, Analyst
That's great color. Thanks, Chuck for the additional comments there. And then switching gears a little bit to just kind of the health of your markets and you talked a little bit about your commercial real estate office portfolio already, and one other area where I'm starting to read that there's some concern and then hear from institutional investors where they're looking as well. And I think this is more a factor in faster growing kind of Southern U.S. markets, but there is some concern in multifamily properties today and from previous conversations. I know you guys feel pretty good about the multifamily markets and demand there, but wondering if you could just refresh me on kind of the thoughts there, the health throughout your Michigan franchise as well as the opportunity to continue to lend there given maybe a lack of supply and excess demand?
Ray Reitsma, COO
Yeah. This is Ray. The housing supply in most markets that we serve is very tight and continues to be demonstrably so. We're certainly not overreacting to that by plunging heavily into that market, but we're continuing to support it for the developers that we know that have resources and a great track record in supplying housing inventory in Michigan. So we haven't really changed our stance on how healthy the market is, and we're continuing to support that activity prudently, maybe even cautiously, but not overzealously.
Bob Kaminski, CEO
Yeah. This is Bob. I'll piggyback on that. Even within West Michigan, which is our largest penetrated market for our company, even with the projects that are on the drawing board with all the developers in all their projects, they're still projected to be a significant shortfall of units that are needed to accommodate the demand as predicted by the local governments. And so we feel really good about our portfolio. As Ray said, we partnered with developers who we've known a long time and who have a lot of experience and have multiple sources of revenue streams. So we feel really good about that. But also on the strength of the market, given the current supply-demand imbalance, that we think it'll continue to bode well for our multifamily, especially here in West Michigan.
Erik Zwick, Analyst
That's helpful. Thank you. And last one for me. Just you guys have a strong capital position, strong pipeline; you're very well positioned to continue growing through organic means. Just curious if you could add any color to the pace of M&A discussions and just your appetite to potentially do a deal if something attractive came your way.
Bob Kaminski, CEO
This is Bob. And I'll answer the question the same way that we always have on that is that we're very selective about potential partners for our company. And as you know, based on our history, we only had one M&A transaction that was in 2014 with our merger. We're very keenly mindful of our culture, and the continuation of that culture has been the key to our success. And so there are a lot of opportunities that have come and gone over the years that may have made sense on paper, but would not have been a good cultural fit. So that mindset still carries for today. There aren't a whole lot of M&A discussions going on right now, given I think some of the uncertainties in the marketplace and in the financial services industry, but if it does continue to loosen up over time and people regain confidence in the banking sector and those opportunities arise, we'll continue to approach it with that mindset is that we're certainly open to M&A, but our success in growing organically has been demonstrated over a number of years, and we'll continue to have that same approach.
Erik Zwick, Analyst
Thanks. I appreciate your thoughts. I appreciate you taking all my questions as well.
Bob Kaminski, CEO
You bet.
Operator, Operator
Our next question comes from Damon DelMonte of KBW. Go ahead.
Damon DelMonte, Analyst
Hey. Good morning, guys. Congrats on a nice quarter and thanks for taking my questions here.
Bob Kaminski, CEO
Thank you.
Damon DelMonte, Analyst
So I guess first question I had was just I think you guys mentioned that there were some payoffs during the quarter that were loans that were kind of under duress. Do you feel like there's more credits that you could be kind of working off the balance sheet over the coming quarters?
Bob Kaminski, CEO
The one that we worked off is, it was the primary target without question as our largest non-accrual borrower. So in terms of others, there are some fairly small and number and amount. And so it shouldn't drive our growth numbers in a negative way to continue that process. Most of the credits that we see that are under duress are one-off management type issues not systemic or economic conditions driven requiring workouts, and so they've been fairly rare. We do have a few that we are working in that direction don't expect those to pay off during this quarter necessarily that's coming up. So I think, in terms of asset quality type pay downs, we'll continue in that similar range to what we've experienced in the recent past.
Damon DelMonte, Analyst
And given the strength of the credit quality across the portfolio, how should we think about the provision level over the next couple of quarters? Do you think something similar to this level is reasonable, or do you feel like you don't need to provide to this extent?
Chuck Christmas, CFO
Thanks, Damon. This is Chuck. At the end of each quarter, we review various factors, and the market's volatility, especially concerning forecasts, plays a significant role. We incorporate available economic forecasts into our models, alongside the standard regulatory qualitative measures, which we haven't altered much recently. Our asset quality remains stable and strong, and we haven't ventured into new kinds of lending or markets, so we are maintaining a steady approach. It's encouraging that we have high loan quality and a robust pipeline. To address your question, overall changes to our loan portfolio in terms of structure and product mix will largely be driven by economic conditions. I anticipate no substantial changes in the loan portfolio's health over the next few quarters as long as the economy follows the current forecasts. Therefore, I believe that any reserves will mainly reflect the growth in our loan portfolio rather than drastic shifts in quality.
Damon DelMonte, Analyst
Got it. That's helpful. Thank you. And then with regards to capital management, Chuck, I think you said about $6.8 million remains on the buyback. What are your thoughts on maybe dipping into the market here and buying back some stock?
Chuck Christmas, CFO
You're right about the $6.8 million. It's been on our agenda, although it's taken a back seat. As we've navigated through the challenges in the banking sector, we've focused on maintaining a strong capital position. Economists keep predicting an impending recession, which we are mindful of. However, we believe our capital is healthy, especially considering our earnings and loan quality. This is an area we'll continue to monitor. We're definitely in a better position now compared to 90 days ago regarding the banking industry. Still, we will proceed cautiously when it comes to stock buybacks. Given the current state of our stock price, we see potential opportunities there.
Damon DelMonte, Analyst
Okay. Great. And then I guess just lastly, any commentary on the mortgage banking market as far as like the purchase market goes? I mean, you put up a pretty good quarter this quarter with gain on the sale of loans. Do you feel like the purchase market, given your footprint remains pretty solid and should continue to produce decent results for you guys?
Bob Kaminski, CEO
Yeah. I think that's a fair characterization. Here in the Midwest, the second quarter will be better than the first seasonally. And there is a continuation of tight supplies we've described already in response to a number of questions. But I think the key for us is the simple recognition that we achieved some time ago that the refinancing just wasn't there anymore and we had to position our sales efforts relative to what is relatively scarce purchase opportunities in the market, but make sure we're there for as many as possible. And that's how we have positioned ourselves. So we've been able to do a relatively good job of getting our share of what are relatively rare opportunities.
Damon DelMonte, Analyst
Got it. Okay. Great. That's all that I had. Thank you very much.
Bob Kaminski, CEO
Thanks, Damon.
Daniel Tamayo, Analyst
Yeah. I thought of a follow-up here. Just I guess it's a couple. First, just you mentioned getting into the tax credit business. Just curious if you could provide a little bit more detail on what that would look like for you guys, timing, expected kind of growth path that kind of stuff?
Chuck Christmas, CFO
This is Chuck. Over the years, we have underwritten numerous deals that included tax credits as part of their structure. However, we previously lacked staff with the necessary expertise to engage in that area. Recently, we've hired a few individuals who possess that expertise. We see significant opportunities in this space and believe it makes sense for us to enter it with our current team and our approach to relationship banking. Our pipeline is looking promising; we are about to close on our first deal next week, which will lead to a gradual reduction in our federal income tax rate. It's still early, and since these are construction jobs, it will take some time before the credits are earned and utilized, so we won’t see a significant impact on our bottom line for the remainder of this year. We expect to start seeing some effect next year and will provide updates regarding our tax rate guidance. Importantly, this adds another tool to our resources, allowing us to be a trusted advisor for our borrowers and contribute to their projects that involve tax credits.
Daniel Tamayo, Analyst
Okay, that's helpful. You provided a lot of detail in your prepared remarks about the reserve calculations in the second quarter, and I believe you mentioned some changes that were made during that time. Can you clarify what you discussed regarding those changes? Were there any adjustments to qualitative aspects or the actual calculations you undertook in the quarter?
Chuck Christmas, CFO
We conducted a thorough review of our model to ensure we were confident in the numbers. This is something we do regularly, but we took a deeper look this quarter. During our review, we examined our migration period, which serves as our baseline allowance, and looked back at actual charge-offs and recoveries since January 1, 2011. We discovered that some recoveries we had recorded were actually tied to charge-offs that occurred before the migration period began. For example, we had a recovery in 2011 for a charge-off that happened in 2009, and we had credited ourselves for the recovery without accounting for the corresponding charge-offs. We corrected this by removing those recoveries from our migration period, which led to an increase in our baseline allocation factors. With CECL, we introduced a historical loss calculation, reviewing the last 20 years to determine our average annual net charge-off rate, which is around 45 basis points. Our previous baseline calculation was approximately 15 basis points. The qualitative aspect reflects this difference. So, our new historical loss number would be 30 basis points following the adjustment. Although we raised our baseline allocation from about 15 basis points to somewhere between 30 and 35 basis points, our historical loss remained at 45 basis points. As a result, even though the baseline increased, the qualitative measurement was able to decrease. The adjustments weren't strictly equivalent due to various factors influencing our baseline calculations, but the significant change was that our calculations are now better supported by quantitative metrics based on cleaner and more relevant data, reducing our dependency on qualitative assessments.
Daniel Tamayo, Analyst
I got it. Okay. So the net was quantitative factor went up and qualitative reserves came down to offset a bit.
Chuck Christmas, CFO
Correct.
Daniel Tamayo, Analyst
Thank you for all that detail. That's it for real this time.
Chuck Christmas, CFO
Thanks, Danny.
Operator, Operator
This concludes our question-and-answer session. I would like to turn the conference back over to Bob Kaminski for any closing remarks.
Bob Kaminski, CEO
Well, thank you very much for your interest in our company. We look forward to speaking with you after the next quarter end in October. This call is now ended. Thank you.
Operator, Operator
The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.