Mercantile Bank Q1: Signs Of Weakening Are Evident (NASDAQ:MBWM)

Just as in its last quarterly report, Mercantile Bank (NASDAQ:MBWM) showed signs of weakness related to its net interest margin. The cost of deposits continues to rise as a result of the increasingly realistic assumption of a “higher for longer” rate scenario, and this is raising some concerns. In addition, the growth rate of commercial loans has slowed significantly: +1.70%, annualized.

Although much of the lending is at variable rates, the pressure of deposits is still too high.

Net interest margin continues to plummet

As mentioned above, high interest rates are inhibiting loan growth, in particular, mortgage loan originations.

A gradual decline has begun since Q2 2023 and that does not seem to have stopped. Households prefer to wait before borrowing at current market rates, and this is disfavoring originations. Among other things, compared to the past, much of the total originations come from refinancing a mortgage already taken out, which further exacerbates MBWM’s difficulty in finding new customers. But there is more.

It is not only businesses and households that bring down the demand for credit; it is also the bank itself. Deciding to issue a loan at 8-9-10% means having full confidence in the borrower, which is not always so obvious.

Assuming Mercantile can find the right customer, it faces another problem: deposits do not cover loans.

The Loan to Deposit Ratio is at 108%, which is far too high and has improved too little since 2020. All this implies a rather rigid financial structure and one that can hardly afford to make new loans until deposits increase.

At most, what it could do is refinance or provide new loans once those already issued have expired. About $2 billion of variable-rate commercial loans will mature within 12 months, but that will not be enough to trigger high growth as in the past. New deposits are needed, which is currently lacking.

Compared to the previous quarter, MBWM increased total deposits by about $100 million, however, their composition deteriorated. As you can see from the pie chart, non-interest-bearing deposits went from 30% to 27%, while money market deposits saw an increase from 23% to 27%. So, a portion of customers who were not receiving interest on their deposits moved to get it. No one can blame them, after all, money market rates are over 5%.

In the previous quarterly I thought this trend was on the home stretch, but after the Fed’s recent statements I expect it may continue for the next few quarters. If rates remain high for a long time, there will be no reason to believe that households and businesses will not continue to shift their liquidity to interest-bearing deposits. This is having a major impact on the net interest margin.

Loan yields continue to grow and averaged 6.65%, up 0.12% from the previous quarter. However, the cost of funds is increasing faster, and has risen from 1.94% to 2.25%: there are no signs of a slowdown.

The result is a declining net interest margin since Q1 2023, whose deterioration was accentuated in this latest quarter. As we will see later, the guidance is not the brightest.

Unrealized losses and guidance

Like almost all banks, MBWM is suffering from unrealized losses of fixed-rate securities.

Compared to the previous quarter, they increased by $2.50 million and reached $60.70 million.

In the last three months the Treasury Bond yield has increased a lot, which is why I expect that in the next quarter the unrealized losses will increase, and not by a small amount. Suffice it to say that the 10-year T-Bond yield was at 3.80% at the end of December 2023, today it is at 4.65% and may continue to rise. A difference of almost 100 basis points, and that will not go unnoticed.

The timing with which MBWM built its bond portfolio was totally wrong. In fact, we can see that the average yield on U.S. Agency Bonds is well below 2%, less than half of current levels. However, management has done a good job on exposure to those bonds. In fact, it has kept their weight low.

Even taking unrealized losses as actual, Tangible Book Value per share would not suffer a dramatic decline. In this respect, there are many regional banks far worse off than MBWM. For the latter, I expect that at most it could end up with unrealized losses in the next quarter that would reduce TBV per share by $5, just as happened in Q3 2022 and Q3 2023.

Finally, let’s take a look at the guidance for the coming quarters.

As mentioned, the cost of deposits will likely continue to rise significantly, overshadowing the growth in loan yields. The result will be a once again declining net interest margin until at least Q3 2024. From then on, management expects a recovery, facilitated by an eventual cut in the Fed Funds Rate. This could bring some breathing room on the cost of deposits.

There is a problem, however: management expects 2 rate cuts, July and October, but futures are discounting only 1 in 2024. So, one of them is wrong, and if it were MBWM then the net interest margin could continue to collapse after Q3 2024. In the no longer remote assumption of a 2024 with no cuts, the guidance will certainly be revised downward.

Conclusion

MBWM is a bank that is struggling to grow due to the worsened macroeconomic environment compared to last year. New commercial loans are suffering, as is mortgage origination. At the same time, the bank is overexposed to commercial real estate.

Even if the concentration ratio does not exceed 300%, the current 245% is still worrisome. In addition, the current Loan to Deposit ratio at 108% limits MBWM’s operations. The higher for longer scenario is not favoring this bank even though 72% of loans are variable rate.

Over the next few quarters, management expects loan growth of 4% to 6%, but I remain quite skeptical of these estimates unless there is surprising growth in deposits-which I do not believe. Just as in the previous quarterly, my rating remains a hold, albeit leaning more toward sell rather than buy.