Mercantile Bank Corporation (NASDAQ:MBWM) Q2 2023 Earnings Conference Call July 18, 2023 10:00 AM ET

Company Participants

Zack Mukewa - Lambert IR
Bob Kaminski - President & CEO
Ray Reitsma - COO & President of the Bank
Chuck Christmas - EVP & CFO

Conference Call Participants

Brendan Nosal - Piper Sandler
Daniel Tamayo - Raymond James
Erik Zwick - Hovde Group
Damon DelMonte - KBW

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. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] 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

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

Thank you, Zach, 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 demonstrates 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 are 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 with 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% of 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 continue to 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

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, 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 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 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 the 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 as depicted in Slide 25 of the investor presentation. Business deposits typically follow a seasonal pattern where commercial deposits contract in the first quarter as clients pay bonuses and taxes and then billed during the remainder of the year. This pattern occurred in 2023 as business deposits decreased by $124 million in the first quarter followed by $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

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 in 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 respective prior year period. The improved net interest margin primarily -- margins primarily reflect 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 increasing in 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 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 increase -- increasing interest rate environment over the past 12 months.

Our loan yields has 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 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 in deposit products to higher cost in deposit products.

We have included a couple of slides in our presentation to picking 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 a second quarter of 2021 to 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 interest rate environment. It is important to note that the same increase in 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 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 chucking 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 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

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

Question-and-Answer Session

Operator

We will now begin the question-and-answer session. [Operator Instructions] Our first question comes from Brendan Nosal with Piper Sandler. Go ahead.

Brendan Nosal

Hey. Good morning, guys. Hope you're doing well.

Bob Kaminski

All right.

Brendan Nosal

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 6.30 (ph).

Bob Kaminski

I don't have a spot margin, but I can get that for you. I think the progression of deposit rates is -- the offered deposit rates have been, I would say, moving steadily throughout most of the first six months. I think in part of that is the interest rate environment has been increasing. Obviously not as much as in 2022, but the Fed has been, as you know, raising interest rates. And as we mentioned, the competition for deposits it's no secret. It's very keen right now.

I would expect that as long as the Fed is increasing interest rates, we'll continue to see some pressure to raise deposit rates. And this is especially true, I should back up with money market and the time deposit products. I think on an overall basis, deposit rates are going to trend as whatever the Fed does. So once the Fed gets done, I hope – I think our offering rates will stay relatively unchanged, relatively high because of the competition. But I don't think we'll see incremental increases into our operating rates once the Fed is done raising interest rates.

Brendan Nosal

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

Our office portfolio is excuse me, 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 giving the general headlines around the topic in the financial press.

Brendan Nosal

All right, perfect. Thanks for taking the questions. Congrats on the quarter.

Bob Kaminski

Thank you.

Ray Reitsma

Thank you.

Operator

Our next question comes from Daniel Tamayo of Raymond James. Go ahead.

Daniel Tamayo

Good morning, guys. Thanks for taking my question.

Bob Kaminski

Good morning, Dave.

Daniel Tamayo

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? Thanks.

Chuck Christmas

Sure, Daniel. This is Chuck. One of the things we talk about all the time and obviously, again, this morning is, we historically see a seasonal withdrawal, net withdrawal of our non0interest bearing deposits from our business customers, especially in January, a little bit in December, but especially in January, and into February again paying taxes, bonuses and the partnerships paying out distributions. And now we will then see a reversal of that trend as we start into the second quarter, because we're going to go through this the seasonality again. So next January, we expect to see yet another decline, so between January of this year and January of next year, we would expect the positive balances to start improving.

And I think what that's kind of what you saw in the second quarter was there was some stabilization. We did see -- this is -- we have obviously a very strong loan portfolio and a lot of that's backed by some very strong operators. And we saw tax payments in April also be a little bit higher than typical. So really since those payments went in mid-April, we've seen some pretty steady growth in the non-interest bearing checking account. And again, we would expect that growth to continue throughout the rest of this year as they build balances back to make the payments next January.

Now I don't think we -- I know I don't expect the non-interest bearing deposit balances to get back to where they were at the end of last year kind of using that as a benchmark. And that's because we are definitely seeing it like all banks are seeing, some transfers of funds from those accounts into -- it's mostly business money market accounts. I think when rates were very low, a lot of businesses just didn’t see the need to be moving money between non-interest bearing and money market accounts. The interest rate differential just wasn't significant enough for that. Clearly, that has changed over the last, call it, 18 months, at least 12 months and so I think a lot of business owners and managers are more keen to that. And so that will temper, I think, the growth that we see in non-interest bearing accounts for the rest of this year. But we do expect some growth. And then of course, we would expect growth in our money market business accounts as well.

Daniel Tamayo

That's very helpful. Thank you, Chuck. I guess, my overall thoughts on, or I should say, just curious kind of how you're thinking about the composition of the -- of your clientele that have those non-interest bearing deposits, you mentioned that you're expecting some pressure and you've seen some moving to interest bearing or asking for that. I mean, is that -- have you looked at the client base in terms of that's the largest customers where that's happening and you're not seeing as much in the smaller customers or is there any other kind of detail you've been able to figure out for what where that pressure is coming from and then kind of how that might relate to going forward.

Bob Kaminski

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

And do you have a breakdown of the average deposit or average size of the clients or, is there, like, a bucketing that you can provide or that you think about in terms of what's moved already and what hasn't and just to give a -- to try and maybe give us an ability to dig in a little bit more in terms of what may be sticky versus what may be more at risk in terms of shifting over to interest bearing?

Bob Kaminski

That information is, it 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

Okay. Fair enough. And then I guess the last question. So I think if I'm reading this right, the fourth quarter net interest margin guidance was raised from last quarter by a bit here. If that's the case, just -- was it just the better than expected margin in the second quarter that drove that or if not, what was the primary driver?

Bob Kaminski

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 a 225 basis point increases that we factored into our numbers this time around that we didn't have three months ago.

Daniel Tamayo

Okay. So if you were kind of extending that forecast out then the -- it would be unchanged, basically, as the rates flow through, I guess, or yeah, I mean, I guess, there's a lot of variables. That's fair. I appreciate it.

Bob Kaminski

Talk to yourself out of it.

Daniel Tamayo

Thanks for all the answer.

Bob Kaminski

You're welcome. Thanks, Danny.

Operator

Our next question comes from Erik Zwick of Hovde Group. Go ahead.

Erik Zwick

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

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

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 and 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

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

Yeah. This is Bob. I'll piggyback on to that. Even with in 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 multi 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

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

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 keen fully 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 have not -- would not have been a good cultural fit. So that mindset still carries for today. There aren't a whole lot of M&A discussion is going on right now given I think some of the uncertainties in the marketplace and in the financial services industry, but it is that continues to loosen up over time and I think people gain -- regain confidence in the banking sector and there are those opportunities.

We'll continue to approach it with that mindset is that we're we are certainly open to M&A, but our success in growing organically has been has been demonstrated over a number of years, and we'll continue to have that same approach.

Erik Zwick

Thanks. I appreciate your thoughts. I appreciate you taking all my questions as well.

Bob Kaminski

You bet.

Operator

[Operator Instructions] Our next question comes from Damon DelMonte of KBW. Go ahead.

Damon DelMonte

Hey. Good morning, guys. Congrats on a nice quarter and thanks for taking my questions here.

Bob Kaminski

Thank you.

Damon DelMonte

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

The one that we worked off is, it was the primary target without questions 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 required 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

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

Yeah. Thanks, Damon. This is Chuck. I think, obviously, we look at things at the end of each quarter and there's a lot of volatility in the market especially with forecasting. And, of course, with [indiscernible], we're all using forecasts that are out there. So we're always subject to whatever any economic forecast updates that we get and run that through our model. We got the qualitatives, the standard regulatory qualitatives that are out there as well. We really haven't done a lot of changes to those over the last several quarters.

Our asset quality has been maintaining a lot of stability, a lot of strength. We haven't introduced new types of lending or new market, those types of things. So kind of steady as it goes. It's a great place to be, that we've got very strong loan quality and a very significant pipeline that we're enjoying and continue to enjoy. So long winded answer to your question is, I think it kind of just depends on mostly on the economics. I don't see over the next couple of quarters any significant changes to our loan portfolio as from a structure standpoint and a product mix standpoint.

So I think it's going to be primarily driven by the economics. Obviously, a big measurement is going to be the actual specific health of our loan portfolio. I think if the economy continues to go along as it's pretty much been forecasted, we don't expect any systemic degradation of our loan portfolio over the next couple of quarters. So having said all that, I think any reserve will really be dominated not just stating what I said will be dominated by any growth that we have in the loan portfolio.

Damon DelMonte

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

Yeah, you're correct on the $6.8 million. That's something that has been on our [indiscernible], although it's been on the back burner. I think as we were trying to work our way through obviously the noise within the banking system and wanting to make sure that we kept our balance sheet from a capital position as strong as we could, the economists, they keep backing off every six months, but the economists keep telling us there's a recession coming. So we want to be mindful of that as well. But we do look at our capital and we find it to be healthy, especially in regards to our earnings performance and our loan quality. So that's something that we'll continue to take a look at.

I think we're more comfortable definitely as we sit here today than we were 90 days ago, especially in regards to what's going on in the banking industry. But I would say that we're just going to be cautious as we move forward to engage in any stock buybacks. But with our pricing the way it has been, our stock price it's certainly something that we look at and see some opportunity there.

Damon DelMonte

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 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

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

Got it. Okay. Great. That's all that I had. Thank you very much.

Bob Kaminski

Thanks, Damon.

Operator

Our next question comes from Daniel Tamayo of Raymond James. Go ahead.

Bob Kaminski

Well, second time through the order, Danny.

Daniel Tamayo

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

Yeah. This is Chuck. I'll start with that. And we have all along the number of years, we have seen -- have underwritten lots of deals that have had tax credits in them as part of the structure. And we just never had anybody on staff that had the expertise to actually engage in that part of the relationship. And so we recently been able to hire a few folks that have that expertise. And like I said, we generally see opportunities in that space and we think we can -- with the people we have on board and our type of relationship banking, we think it makes a lot of sense.

To enter that space, there are -- the pipeline is pretty good already. I think we're actually closed on our first deal next week. And what that will end up being is a reduction of our federal income tax rate over time. And still definitely early in the game to have -- these are all construction jobs, so it takes a while for the credits be earned and then obviously used. So nothing significant to our bottom line the rest of this year.

We'll start seeing some impact now year and obviously, we'll update given our guidance as we do provide guidance on our tax rate. But that's where the true benefit for the income statement is really going to come through. But I think just as importantly is yet another quiver, high an arrow in our quiver that we can be that trusted advisor to our borrower customers and be able to provide yet one more piece of the puzzle that they're working on with their specific projects that happen to involve tax credits.

Daniel Tamayo

Okay. All right. That's helpful. And then you gave a lot of detail on -- in your prepared remarks about the reserve calculations in the second quarter. And I think you mentioned changes that you made in the quarter. If I'm correct, can you just kind of refresh me on what you said happened there if there were any kind of changes if they were either changes to qualitative or changes to actual calculations that you made in the quarter. Did I hear that?

Chuck Christmas

Yeah. So what we did is, we did our -- we did a really deep dive into our model and just making sure that we were comfortable with the numbers. Obviously, it's something we kind of do on a regular basis but took a pretty deep dive this quarter. And one of the things that we found in looking at it back at our migration period, which is our baseline allowance if I look at the actual charge offs and recoveries dating back to January 1, 2011.

And what we had found is that we had some recoveries in our numbers during that time period from 2011 on that the charge offs actually took place before the migration period started. So we had a recovery stay in 2011 where the charge off was in 2009, but we were given ourselves credit, if you will for the recovery without the corresponding charge offs. So we went ahead and cleaned that up by eliminating those recoveries from our migration period, which then resulted in our baseline allocation factors going up.

Now one of the things that we introduced with CECL from a qualitative standpoint was an historical loss calculation. And what we do with that is we go back over the last 20 years and calculate what our average annual net charge off number was and let's just say it's 45 basis -- it's about 45 basis points. We look at our baseline calculation which I think previously was around 15 basis points give or take. So our qualitative would be the difference to that.

So we would do our baseline, which has a lot of impact in other areas of our calculation. But from a qualitative standpoint, we said our historical loss should be kind of be our diminish when we're looking at that. So in that example, our historical loss would be 30 basis points. Now that we've updated our baseline allocation, it went from 15 -- and I make it up – not making these numbers up, but are using very general numbers. Our baseline went from 15% to up to I think, 30 basis points or 35 basis points.

Our historical loss didn't change from the 45. So while our baseline went up, the quantitative measurement, our qualitative was able to come down. It wasn't exactly a dollar for dollar because there's a lot of other things that go on with the baseline calculations in our model. But that was the big moving piece was making our calculation more supported by quantitative measurements with [indiscernible] cleaned up data, more appropriate reasonable data and less reliance on qualitatives.

Daniel Tamayo

I got it. Okay. So the net was quantitative factor went up qualitative reserves came down to offset a bit.

Chuck Christmas

Correct.

Daniel Tamayo

Thank you for all that detail. That's it for real this time.

Chuck Christmas

Thanks, Danny.

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

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

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