Mercantile Bank Corporation (NASDAQ:MBWM) Q1 2022 Earnings Conference Call April 19, 2022 10:00 AM ET
Company Participants
Kate Croft – Lambert, Investor Relations
Robert Kaminski – President and Chief Executive Officer
Charles Christmas – Executive Vice President and Chief Financial Officer
Ray Reitsma – Chief Operating Officer and President of the Bank
Conference Call Participants
Brendan Nosal – Piper Sandler
Daniel Tamayo – Raymond James
Damon DelMonte – KBW
Bryce Rowe – Hovde Group
John Rodis – Janney Montgomery Scott
Operator
Good morning and welcome to the Mercantile Bank Corporation First Quarter [2022] [sic] Earning Results Conference Call. All participants will be in a 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 now like to turn the conference over to Kate Croft, Lambert Investor Relations. Please go ahead.
Kate Croft
Good morning, everyone and thank you for joining Mercantile Bank Corporation’s conference call and webcast to discuss the company’s financial results for the first quarter of 2022. Joining me today are members of Mercantile’s management team, including Bob Kaminski, President and Chief Executive Officer; Chuck Christmas, Executive Vice President and Chief Financial Officer; and Ray Reitsma, Chief Operating Officer and President of the Bank. We will begin the call with management’s prepared remarks and presentation to review the quarter’s results, then open the call up for 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 the factors described in the company’s latest Securities and Exchange Commission filings. The company assumes no obligation to update any forward-looking statements made during the call. If anyone does not already have a copy of the first quarter 2022 press release and presentation deck issued by Mercantile today, you can access it at the company’s Web site, www.mercbank.com.
At this time, I would like to turn the call over to Mercantile’s President and Chief Executive Officer, Bob Kaminski.
Robert Kaminski
Thank you, Kate, and good morning, everyone. On the call this morning, we will provide you with detailed information on the company’s performance in the first quarter as well as updates on the current operating environment. We are pleased to begin the year with a solid first quarter performance, highlighted by an operating profit, prudent expense management, continued growth in core commercial loans contributing to a higher net interest income, and pristine asset quality. The dedicated efforts of our team in tandem with the strong foundation we have built are the keys to our continued success.
In the first quarter, we reported net income of $11.5 million or $0.73 per share. Total assets were $5.18 billion, with loans growing to $3.56 billion, at March 31. Our performance was once again headlined by growth in the commercial loan portfolio. New loan opportunities continue to be cultivated in all of our markets, including requests from borrowers with smaller credit needs, which is a characteristic of our rural markets, in addition to larger more complex loan needs which are typical in our metro markets. These opportunities are possible because of the superb work of our lending staff in gaining familiarity with the businesses of prospective clients, understanding their opportunities, challenges, and needs, and then adding value to the relationship as a trusted advisor. Ray will provide more details on the loan portfolio metrics in his comments.
While our mortgage banking income is down year-over-year from 2021, while low interest rates allowed for significant refinance volume, our keen focus on purchase business and the addition of commission-based real estate lenders are providing benefit to us during this time of rising interest rates. Mortgage production has migrated to loans retained in the portfolio, and construction loans, as many customers are opting to build new houses since the availability of existing homes is limited. Despite the reduction in mortgage banking income, we are confident in our ability to continue to be a top performer in this area during 2022. We made a number of strategic lender hires throughout our footprint during 2021.
Together with new offices in Petoskey serving a very attractive Lake Michigan second home region, as well as the economically vibrant Cincinnati market, we believe our team is well-positioned to be the bank of choice for new and existing customers. Our team was successful in generating growth in several fee income categories during the first quarter compared to the same period in 2021, including service charges, credit and debit cards, interest rate swaps, and payroll services. This growth is the result of ongoing strategic initiatives to understand our customers’ needs, and ensure that customers are aware of the full suite of Mercantile products that can help to fulfill those needs. Ray and Chuck will provide more specific details following my comments.
We continue to make appropriate investments to recruit and retain high-performing talent that has been and will remain the key to growing the number and depth of Mercantile customer relationships. This includes our exceptional branch and customer service staff. Accordingly, in February, we implemented a $1.00 per hour wage increase for all nonexempt employees. At the same time, office optimization plus the shift to a remote work option for certain employees should allow us to reduce our facilities costs which will help offset the increases to our salaries and benefits. We aim to strike the right balance between investing smartly in our team and technology, while managing expenses to enhance our profitability.
Regarding the Michigan economy, while the overall statewide unemployment rate is 4.4%, down from the 6.3% of a year ago, in the metro markets, which contains the most significant concentrations of assets in Mercantile and business opportunities, the unemployment rate is below 4%. With this low unemployment rate, many companies face challenges in attracting new employees, in the construction industry, for example, many firms are having a difficult time identifying skilled workers, and this is slowing productivity. With a tight supply of housing inventory, many new homeowners and consumers desiring to upgrade their dwellings are turning to new construction.
With current housing market conditions and supply chain challenges, construction productivity creates yet another issue; capital expenditures continue to trend upward as companies look to implement technological upgrades to their equipment and plant expansions. Our clients [have it directly] [Ph] managed through the challenges over the past two years, since the onset of the COVID-19 pandemic, and we expect they will continue to do so in 2022. But we remain closely engaged with them, of course, to assess the effects of rising costs, including anticipated increased borrowing costs.
Finally, I want to compliment the Mercantile team for their spectacular performance to start 2022. Their tireless work to ensure that Mercantile’s relationship-based approach, which is the hallmark and the foundation of our culture, is reflected in our daily engagement with our customers and potential customers.
Those are my prepared remarks, and I’ll now turn the call over to Ray.
Ray Reitsma
Thanks, Bob. Today my comments will center around three topics and evidence in our quarterly results for 2022: strong commercial loan growth, strategic diversity of sustainable non-interest income, and pristine asset quality. For the first quarter, we are reporting core commercial loan growth of $82 million, or 11% annualized. This growth was achieved despite payoffs related to asset or business sales of $46 million. It has been possible due to the efforts of our commercial team and their focus on relationship building and the business community bank value proposition. Our backlog remains consistent with prior periods as we fund this impressive level of growth, availability under construction commitments that we expect to fund over the next 12 to 18 months totaled $184 million.
Secondly, strategic diversity and sustainable non-interest income; for the first quarter, we’re reporting non-interest income of $9.3 million, compared to $13.5 million in the comparable period last year, a reduction of $4.2 million. Mortgage banking income decreased by $5.5 million to $3.3 million. This reduction occurred due to a 60% decrease in refinancing originations, which [massed] [Ph] a 24% increase in purchase originations, indicating that our mortgage production team continues to successfully pivot to the purchase market. Our other diverse non-interest income categories reported total increases of $1.3 million, led by 107% increase in interest rate swap income, a 23% increase in service charges on accounts, a 15% increase in payroll services, and a 12% increase in credit and debit card income. Each of these income streams are sustainable as the interest rate environment fluctuates.
Finally, the bank continues to experience pristine asset quality with zero ORE and three basis points of non-performing assets at the end of the first quarter of 2022 compared to $0.4 million of ORE and seven basis points as non-performing assets at the end of the comparable prior-year period. This level of asset quality supports an allowance to loans ratio of 0.99% as of March 31, 2022 and a provision for credit loss expense of $0.1 million during the first quarter, compared to $0.3 million in the comparable period last year.
That concludes my comments. I will now turn the call over to Chuck.
Charles Christmas
Thanks, Ray. Good morning to everybody. As noted on slide 24, this morning we announced net income of $11.5 million, or $0.73 per diluted share for the first quarter of 2022 compared to $14.2 million or $0.87 per diluted share for the respective prior-year period. Ongoing strong core commercial loan growth, continued strength and asset quality metrics and increases in several key fee income revenue streams in large part mitigated a significant decline in mortgage banking revenue as industry wide originations come off of 2020 and 2021 record levels driven by low mortgage loan rates and resulting refinance activity.
Turning to slide 25, interest income on loans during the first quarter of 2022 increased $0.3 million from the year-ago first quarter, as growth in core commercial loans and residential mortgage loans offset lower PPP net loan fee income accretion. Interest income on securities in the first quarter of 2022 increased $0.6 million from the first quarter of 2021, in large part, reflecting growth in the securities portfolio over the past 12 months to meet internal policy guidelines and deploy a portion of the excess liquid funds position. Interest income on other earning assets, a vast majority of which is comprised the funds on deposit with the Federal Reserve Bank of Chicago increased $0.2 million during the first quarter of 2022, compared to the year-ago first quarter, primarily reflecting increased balances.
In total, interest income for the most recent quarter increased $1.1 million from the first quarter of 2021. Interest expense on deposits during the first quarter of 2022 decreased $0.9 million from the year-ago first quarter, as lower deposit rates more than offset increased interest bearing deposit balances. Interest expense on other borrowed money in the first quarter of 2022 increased $0.8 million from the first quarter of 2021 in large part reflecting the issuance of $75 million in subordinated notes in December of 2021, and a $15 million follow on issuance in mid-January. In total, interest expense for the most recent quarter declined $0.3 million from the first quarter of 2021.
Net interest income increased $1.4 million during the first quarter of 2022, compared to the first quarter of 2021. We recorded a credit loss provision expense of $0.1 million for the first quarter of 2022, compared to the provision expense of $0.3 million during the prior year first quarter. Net loan recoveries and continued strong loan quality metrics in large part mitigated additional reserves associated with the loan growth. We adopted CECL effective January 1, 2022, with a one-time reduction of $0.4 million to the reserve balance recorded on that date.
Continuing on slide 27, overhead costs during the first quarter of 2022 increased $0.6 million from the year ago first Quarter. Salary and benefit costs were up $0.4 million, in large part reflecting merit pay increases, market adjustments and promotions over the past 12 months.
Continuing on slide 28, our net interest margin was 2.5%, 2.57% during the first quarter of 2022, down 17 basis points from the fourth quarter of 2021 and average during all of 2021. Compared to the year ago first quarter, the yield on earning assets decreased 27 basis points, primarily reflecting a decline in loan yields associated with lower PPP net FY accretion.
As noted on slide 23, net fee income accretion totaled $0.8 million during the first quarter of 2022 compared to $2.8 million during the first quarter of 2021. A vast majority of the remaining unrecognized net PPP fee income of $0.2 million is expected to be recorded during the second quarter. The funds declined seven basis points for the most recent quarter compared to the year ago quarter. The cost of deposits decreased 12 basis points, which more than offset an increase in the cost of borrowed money associated with the issuance of subordinated notes.
Our net interest margin continues to be negatively impacted by a significant volume of excess on balance sheet liquidity depicted by low yielding deposits with the Federal Reserve Bank of Chicago. The excess funds are a product of increased local deposits, which are primarily a product of federal government stimulus program programs as well as lower business to consumer investing in spending.
Overnight deposits average $784 million during the first quarter of 2022 compared to $592 million during the first quarter of 2021 and $671 million during all of 2021 substantially higher than our typical average balance of around $75 million. The excess liquidity lowered our net interest margin during the first quarter of 2022 and all of 2021 by about 40 to 45 basis points. While, we expect the level of excess overnight deposits to decline in light of continued loan growth and wholesale fund maturities. We expect the level of overnight deposits to stay elevated well into the foreseeable future. Given the asset sensitive nature of our balance sheet, any further increases in short-term interest rates would have a positive impact on our net interest margin and net interest income.
We remain in a strong well-capitalized regulatory capital position. The Tier 1 leverage capital ratio continues to be impacted by excess liquidity. Although there is no similar impact on the risk-based capital ratios as deposits maintained at the Federal Reserve Bank of Chicago are assigned a 0% risk weighting. Both our Tier 1 leverage capital ratio and the total risk-based capital ratio have also been impacted by strong core commercial loan growth over the past several quarters. Our total risk-based capital ratio and all of our banks regulatory capital ratios were augmented this past December in January, with an aggregate $90 million issuance of subordinated notes, of which a massive majority of the funds were downstream to the bank as a capital injection.
As of March 31, our total risk-based capital ratio was 14.1% compared to 12.5% as of September 30, 2021. Our bank’s total risk-based capital ratio was $157 million above the minimum threshold to be categorized as well capitalized at the end of the first quarter. We did not repurchase shares during the first quarter of 2022, given the recent stock price, and prospects for additional solid loan growth, we do not plan to purchase additional shares, at least in the near-term. We have $6.8 million available in our current repurchase plan.
On slide 32, we share our latest assumptions on the interest rate environment and key performance metrics for the remainder of 2022, with the caveat that market conditions remain volatile, making forecasting difficult at best. As you can see, we are currently expecting fee income, overhead costs, and our tax rates remain relatively consistent for the remainder of the year. We are projecting the FOMC to increase the federal funds rate at each of the next four meetings, including a 50 basis point increase in early May. Based on this rate projection along with the reduction of excess liquidity, we are forecasting our net interest margin to improve in each of the next three quarters. For information regarding our floating rate loans and repricing opportunities, please refer to slide 18.
In closing, we are pleased with our operating results and financial condition as we begin the 2022 campaign, and believe we remain well-positioned to continue to successfully navigate through the myriad of challenges faced by all of us.
Those are my prepared remarks. I’ll now turn the call back over to Bob.
Robert Kaminski
Thank you, Chuck. That concludes management’s prepared comments. And we’ll now open the call to the question-and-answer period.
Question-and-Answer Session
Operator
Thank you. We will now begin the question-and-answer session. [Operator Instructions] And the first question will come from Brendan Nosal with Piper Sandler. Please go ahead.
Brendan Nosal
Hey, good morning, folks. How are you doing?
Robert Kaminski
I’m good. Good morning.
Brendan Nosal
Good. Maybe just to start off on kind of the NII outlook that you provided on slide 32, I do get that part of the NIM expansion that you’re forecasting is, one, a function of rates moving higher and, two, a function of some liquidity rolling off the balance sheet. I’m sure that I could do the math myself, just curious how much of that margin improvement do you think is really a function of rates moving higher?
Robert Kaminski
I think most of the expected increase is from the rates, but we are expecting a reduction in some of that excess liquidity, although, as I mentioned, we still think it’s going to be relatively elevated even by the end of this year. I think if you look on page 32, with the average earning assets, we expect loan growth to be somewhat similar for the remainder of this year as to what it was in the first quarter. But you can see that average earning assets are trending downward, at least for the next couple of quarters before it flattens out. And, of course, what that is, is really a net of the loan growth less the expected runoff of some of our excess liquidity.
Brendan Nosal
Yes, that makes perfect sense. Okay, good. Maybe one more from me just on the expense outlook, so [cost obviously, sell] [Ph] quite a bit from the first quarter as [comp] [Ph] accruals reset, which is certainly nice to see. So, I guess, just going forward in that, the outlook you provide for expenses, is it safe to assume that that includes accruals for what is appearing to be a good NII outlook given rate increases?
Robert Kaminski
Yes. Yes, that takes into account what we think the rates are going to do for the rest of this year, and the associated impact on our overhead costs for the remainder of the year.
Brendan Nosal
All right, wonderful. Thank you for taking the questions.
Robert Kaminski
Thank you.
Operator
And the next question will come from Daniel Tamayo with Raymond James. Please go ahead.
Daniel Tamayo
Morning, guys.
Robert Kaminski
Danny, good morning.
Daniel Tamayo
And maybe just starting on the loan growth, you just talked about that guidance kind of remaining similar to what we saw in the first quarter, which is great. First quarter had a little more [1-4] [Ph] family growth than I was expecting. Can you talk about what the type of mix of growth you’re expecting going forward, and if there was anything unusual in the first quarter?
Robert Kaminski
Yes, I think in regards to the residential mortgage area we continue to kind of go along with what we had structured for the last several years, and that is to sell a vast majority of our fixed rate loans, but then the book, our ARMs, which are primarily 5/1 and 7/1 ARMs. We are looking into potentially finding some investors for the ARM products as we go forward, as we have seen the ARM product become a little more popular with our client base. Quite frankly, we would like to see a little less on balance growth with our residential mortgage loan portfolio, but, clearly, we want to make sure that our mortgage operation stays very strong and that we’re providing the products that our customers are asking for. So, it’s kind of — there’s kind of more of a balance there, but definitely the trend is there for additional growth, and we’re looking for ways to maybe mitigate that.
Charles Christmas
I would supplement that point with the fact that construction mortgages have become more popular, roughly twice as high as the previous quarter. And that has the impact of staying on the balance sheet during the construction period and reducing the amount of loans that are sold while we wait for those to complete construction.
Daniel Tamayo
Okay, great. And then switching gears here to the fee income, and appreciate you guys putting guidance on that last slide, that’s very helpful. Within the fee income, obviously mortgage banking took a big hit in the quarter, and you talked about the refi versus purchase dynamics a little bit. Was there — can you give what the gain on sale rate was in the quarter, and what the change was from last year, the fourth quarter, and if there was any MSR change in that number as well?
Robert Kaminski
I think on the gain rate, we’re going to probably have to get back to you Danny. I don’t — I mean, we’re looking at each other; I don’t think either of us have that. As far as the MSRs, we haven’t seen a huge impact. We do a lower cost to market so there’s no fair value adjusting going on there. We certainly continue to see some acceleration from some refinance activity. Clearly, we see a decline in refinance activity. So, accelerated amortization of mortgage servicing rights is slowing down. And we would expect that to continue to slow down, which, of course, would be a tailwind for mortgage banking income as we go forward. But, clearly, the production, and especially the volume of sold versus portfolio is going to be a bigger player on that number.
Daniel Tamayo
And just kind of bigger picture, the — that the number came — the run rate, if you will, I guess came way down in the quarter. And you’ve talked about that the focus on growing the purchase side, if you — is this the new run rate that you’re still expecting that would come down as refi volumes decline from that 3.3 million number and how are you thinking about where you might end up in a normalized environment, in terms of volumes at least?
Ray Reitsma
I’ll give you a general answer, and I’ll let Chuck follow-up with the specifics. But seasonally, here in Michigan, we do expect a pick up in activity as we move from the first quarter into the second. And the second quarter and the third are seasonally strong for us here in the lovely state of Michigan, it’s weather-driven, school-driven, like it is everywhere else. So, we would expect to see some recovery there from a seasonal pattern, as been evident every year.
Robert Kaminski
I think as we also mentioned, another factor into the mix is the limited supply of homes that are available for sale. And as I mentioned in my comments, Danny, many customers who would just assume buy an existing home are frustrated by the lack of availability, so they’re opting for a construction process which, with some of the challenges that we’ve outlined, are — takes a little bit longer too. So, as Ray hit on that number, we’ve seen a significant increase in our construction commitments here in the first quarter. And I think as long as the current housing inventory remains low, I think you’ll see customers exploring that as a possibility because they desired a new home and there’s just nothing available from an existing home standpoint. So, they’re looking at all options, but a lot of dynamics in the market right now affecting customers’ decisions.
Charles Christmas
Yes, I think, Danny, if I — this is Chuck again, if I could add to that is when you look at our fee income performance for the first quarter, apart from the mortgage banking, we think that the trends that you saw in the first quarter will continue for the rest of the year. And as Ray mentioned, we had solid growth in some of our more ongoing and core fee income, especially on the treasury management side of things. Though the big wildcard, as we’re talking here and trying to answer your question as best we can, is mortgage banking. And there’s just so many moving parts to it that becomes somewhat difficult to try to narrow that down. We’re very, very pleased with our mortgage operation, clearly us and the industry certainly enjoyed very, very strong refinance activity over the last calendar, two calendar years and other attributes as well including a pretty high gain rates in the marketplace.
But with the increase in mortgage rates, the refi area is drying up pretty significantly, and reliance on purchase is going to become a bigger and bigger issue. And all along, as we go out and hire additional commercial mortgage lenders, we make sure that they have the ability to be high performers in kind of a purchase only market that we seem to be entering into.
So, clearly, we’re not going to make and I think I can speak for the industry, we’re not going to make the lofty numbers that we had last couple of years, but I think as Ray mentioned, we saw really solid growth in the purchase volume that we’ve gotten, and think we’re doing a good job and our lenders are doing a really good job of being out on the Streets and getting a higher volume. And I would dare say that we believe that we’ve increased our market penetration and it’s just in a different market.
Ray Reitsma
And one other tidbit I’d throw on there, Daniel, is that all the numbers that we’ve referenced so far have related to close volume, if you move a step further and look at the applications, they show a continuation of that trend, the applications that we have for purchases and construction are higher by a similar percentage as close volume, so there are like 25% over what they were last year at this time. And similarly the apps for refinance are down in that 60% range. So, if you move from what’s closed to what we anticipate closing based on applications in process, yes, the trend will continue.
Robert Kaminski
I think looking at our mortgage production for the first quarter, those numbers are pretty much on track with what we were expecting for the first quarter, the main differences, the percentage of loans that we’re selling, and the mix of the type of loans that we’re generating leaning towards construction. So, I think in the end, it’ll all wash out and end up as we have projected just there are variables along the way that are certainly affecting what’s falling to that mortgage production income, mortgage banking income in any one quarter.
Daniel Tamayo
That’s perfect color. I really appreciate that particularly as it relates to the impact on loan growth. That’s all I had. I appreciate that.
Robert Kaminski
You’re welcome.
Operator
Thank you. And the next question will be from Damon DelMonte with KBW. Please go ahead.
Damon DelMonte
Hey good morning, guys. How’s everybody doing today?
Robert Kaminski
Good morning, Damon. How are you?
Damon DelMonte
Doing great. Thanks. So, first question is want to talk a little bit about loan growth, you guys sound pretty optimistic on the commercial side of things. Do you think that kind of keeping the commercial growth rate at that high single, low double-digit range is doable for the remainder of the year? Do you think it kind of comes back to the more the mid to upper single-digit range?
Robert Kaminski
I would say that based on all the information we have right now, we’d expect to continue along the pace that we demonstrated in the first quarter is we look at our backlogs opportunities and all the surrounding information, it appears that the immediate future looks a lot like the past.
Ray Reitsma
I would add, the unknown that we have and of course we had some in the first quarter is the payoffs, and so, when we look at our pipelines and all the trends, we definitely see a lot of momentum there, and believe we will hit on that. But it’s just a matter of the payoffs that come in as borrowers sell their projects or the underlying assets. That’s the unknown, trying to factor in a commercial loan growth.
Damon DelMonte
Got it, and is there any particular region of your footprint or area of your footprint that is showing better opportunity than others?
Ray Reitsma
Not particularly, Grand Rapids is always a strong market for us. We’re very well represented here by our commercial loan team and long history of participating in that market, but they’re all fairly robust.
Damon DelMonte
Got it, okay. All right, that’s great. And then, on the credit side, you guys finally adopted CECL as a one-one in 2022, you had a modest budget adjustment to your reserve level, Chuck can you help us just think a little bit about what the outlook would be for provision expense, especially with the strong outlook for loan growth like should we start to see a more normalized level of provisioning?
Ray Reitsma
That is a new normal.
Charles Christmas
You don’t maybe talking about CECL at this point; clearly, the loan growth necessitates additional reserves. And while we don’t like making provisions, we certainly want to make sure we keep our reserve adequate, which is reflective of that loan growth. And of course, we were very proud of our very, very strong credit metrics, which if you look at just those, it makes it difficult to increase reserve of any notable size, which means that you’re heavily reliant on your qualitative measurements and those factors. So, really I think while the growth is certainly going to be there, or we think it’s going to be there, and that’s going to result in some reserve increases like it did the first quarter, it’s kind of more of to answer your question in a very long winded way is more about what happens with those qualitative factors. The big one of course, which is pretty much out of our control is the economic forecast is we use a third-party and look the market for that.
When you look at expected GDP growth, unemployment rates, those types of things over the next couple of years, those are still pretty strong and pretty frothy, which doesn’t add a lot to your reserve calculation, as a matter of fact, as of the end of the year, and so as the end of March is actually a small negative to our reserve calculation on the economic factor. So, we would expect that probably as we move along that quarter-over-quarter maybe the economic forecast isn’t as strong and maybe we’ll see the need to add to our reserves.
As we move along, I would say that’s just not Mercantile, I would say that impacts any bank that’s adopted CECL, but I would also say, we’ve got other factors in here, we have quite a bit of money in our reserve associated with COVID. Not just the disease itself, but all the impacts, that it has supply chains and all those things that we know about, there’s quite a bit of money in the reserve for that factor, hopefully over time, we can start peeling some of that away. I definitely look forward to that. And then, of course, we’ll just keep an eye on all the other normal regulatory factors that we have. So, I can’t give you a solid answer. I think that right now, what we saw in the first quarter, seems to be what I would expect and at least in the next couple of quarters. But that makes the assumption that there’s no significant change in economic forecasting.
Ray Reitsma
I will add that just pure commercial loan growth in of itself does not contribute a whole lot to the reserves under CECL because of the duration of those commercial loans is on the short side, compared to longer-term residential mortgage loans, so just by growing the commercial portfolio, absent the other factors that Chuck talked about, with qualitative and asset quality, the growth itself does not require the addition of a whole lot of reserves as much as you might think, based on the incurred loss model, which we just came off of.
Charles Christmas
Yes, and that’s one of the reasons why we delayed CECL as long as we could, because we know what to be a duration based model, we’re obviously a commercial bank with a duration of barely over two years. And so, when you look at it, when we book a dollar of mortgage loans, and a dollar of commercial loans, the mortgage loan takes twice as much reserve as what the commercial loan does. We don’t agree with that. That’s the way that the framework works. So, we have to, we have to deal with that. But then therefore, you have a lot more reliance on environmental factors on the commercial side to support some higher reserve dollars.
Damon DelMonte
Got it, okay, that’s great color and very helpful. And then, just one final question on expenses, I apologize if this was said either in response to a question or in your prepared remarks. But the guidance is obviously a step-up from where we were this quarter. Did you say that or would you say that salary and benefits and like data processing are the two main drivers of the step-up going forward versus this past quarter?
Charles Christmas
Yes, that’s correct. I think and I think Bob mentioned in his opening remarks, we did a pay raise for all of our hourly people towards the end of the first quarter. So, there’s the ongoing costs associated with that, but so, yes, as always when you look at the makeup of our overhead as salaries and benefits and as data processing costs that are the big numbers and changes in dollars are going to be the primary drivers of any changes in our overhead costs.
Damon DelMonte
Got it, okay. That’s all that I had. Thank you very much, guys. Appreciate it.
Charles Christmas
Thanks, Damon.
Operator
And the next question will be from Bryce Rowe from Hovde Group. Please go ahead.
Bryce Rowe
Thanks, good morning, guys. How are you?
Charles Christmas
Good morning.
Robert Kaminski
Good morning.
Bryce Rowe
Wanted to, I appreciate all the kind of the detail in the in the discussion around CECL. I understand it’s a moving target so to speak. Maybe one question on the margin and the margin outlook that was provided there in the deck, what level of deposit beta are you kind of assuming with these rate hikes? And are you thinking about each subsequent rate hike any differently from a deposit data perspective?
Robert Kaminski
Yes, that’s a great question because of all the things that we talked about mortgage bank and some others that are difficult to forecast deposits are just there. Obviously, all the banks including Mercantile have seen significant deposit growth over the last couple of years. We don’t think it’s all going to stay, we think a fair amount of it’s going to stay. But when the money starts actually when the balances start leaving you know, they started to be invested, started to be spent, or whatnot. That of course, has a play into the margin calculation and excess funding and all that type of thing. So, we have to have some expectations for that. And I would say, so far, we’ve seen very little in the way of deposit withdrawals as a matter of fact, we generally have — we have some seasonality here at this bank, where we generally lose about $100 million in primarily checking account balances in January, as our customers pay bonuses and taxes and stuff like that. That didn’t happen this year. It’s seasonal for us. But if you exclude the one withdrawal from the large depositors that made large deposit in the last year, we actually saw net deposit growth during the first quarter. So, in a quarter that and that we generally see a reduction in deposits, we actually saw more growth.
So, we love deposits, we know at some point in time down the road, we’re going to want more deposits, but we clearly have many now, but what we don’t see is a lot of money changing banks, you know, the rates are so quite low. And there’s really not much of an incentive from a rate perspective for people to start moving money from bank-to-bank. There’s just not a lot of competition out there for deposits given a vast majority of the banks out there have plenty of excess deposits on hand. I bring that up because that certainly impacts deposit rates. As we know, deposit rates are impacted primarily by two things. One is the overall interest rate environment, which obviously is increasing and additional increases are expected, but it also — the demand for the deposits has a big play as well. And so, what we have seen at least so far and we only have one increase so far, of course is that deposit rates in our markets change very little at least after the first fed increase. Rates are — and we’re surmising here, but rates are very, very low and I think a lot of depositors have — are somewhat indifferent because of those low rates. However, we think that is going to change as it’s in the market. It’s in the news that the Fed is getting more aggressive with rates. Obviously, folks see what’s going on with mortgage rates, they’ll probably become more attentive to what’s being paid on deposits. And perhaps that will put some pressure on us have as a market as an industry to have to have to raise deposit rates as we move forward. But to the degree that they’re going to move going forward is kind of really anybody’s guess.
On the assumptions that I provided and our forecasts, ideas and thoughts that I provided, we kind of use more of our historical betas, which are probably more aggressive. Clearly, we want to be somewhat conservative and putting out our expectations. So, they’re relatively aggressive because we’re using historical numbers. I use those consistently throughout the rest of the year. But I think it’s probably more likely that the betas will be relatively low and slow at the beginning, and will probably speed up as we move on and we get more increases from the Fed. So, that’s kind of our thoughts, is that we’ll probably eventually come out at an average of betas. But and so we budgeted or forecasted at an average level, but it will probably be a little less at the beginning and a little more beta at the end.
Bryce Rowe
That’s perfect. Thanks, Bob.
Robert Kaminski
You’re welcome.
Operator
[Operator Instructions] The next question will be from John Rodis from Janney. Please go ahead.
John Rodis
Good morning, everybody.
Robert Kaminski
Good morning.
John Rodis
Chuck, a question for you on the securities portfolio, just given your outlook for average earning assets, should we sort of assume securities are flat down going forward given the outlook for loan growth?
Charles Christmas
Yes, I think I have a little bit of an increase in that portfolio, John, but I don’t I think I have a little bit of an increase in our portfolio, John, but I don’t think — it’s nothing material. So, what do you see in the average earning assets is the security stay in relatively stable, the growth in loans as we’ve talked about, and then the net is the reduction in excess funding.
John Rodis
Okay, okay. Just one more question, and hopefully you didn’t already answer this. Just in the prepared remarks, I think you talked about the payoffs in the quarter, and you said a third of the payoffs were experiencing some financial difficulties. Could you maybe just give some more details on those difficulties?
Charles Christmas
There were performance difficulties, largely related to the industry they were in relative to the pandemic environment. And I believe one was hospitality, one was an entertainment venue obviously impacted by the environment. And so, their performance during that particular time was depressed.
John Rodis
Okay. And Ray, do you see more exposure there, or — you know, as it relates to those industries and stuff that would give you pause?
Ray Reitsma
Not at this point. We feel pretty good about our remaining portfolio. Our watchlist is at a low point historically, and most of those types of credits have performed quite well I believe.
John Rodis
Okay, fair enough. Thank you, guys.
Ray Reitsma
Welcome again.
John Rodis
Thank you.
Operator
Ladies and gentlemen, this concludes our question-and-answer-session. I would like to turn the conference back over to Bob Kaminsky for any closing remarks.
Robert Kaminski
Thank you very much for your interest in our company. We look forward to speaking with you next at the end of the second quarter. This call has concluded.
Operator
Thank you, sir. The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect your lines.
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