Mercantile Bank Stock: Q4 2023 Analysis (NASDAQ:MBWM)

Mercantile Bank (NASDAQ:MBWM) is a Michigan-based bank and has $5.25 billion in total assets. Unlike many other regional banks, MBWM has already fully recovered from the period of severe distrust triggered by SVB’s bankruptcy and is close to an all-time high. Its NIM has remained quite high due to the prevalence of variable-rate loans and has managed to handle the turbulence of the current macroeconomic environment fairly well.

Loans, deposits and NIM

In Q4 2023, NIM stood at 3.92%, a decline from previous quarters albeit by a minimal amount. Compared to Q4 2022, there was an overall reduction of 38 basis points.

The main cause of this deterioration always lies in the usual problem of the last year: the cost of funds continues to rise because of the high Fed Funds Rate. As the money market offers rates in the 5% range, obviously depositors demand a higher yield to keep their funds immobilized. As a result, MBWM is forced to give more interest if it does not want to suffer a major outflow of liquidity.

This process has been going on for months, but it would seem that it has finally come to an end.

According to what was discussed in the conference call, management expects that there may be one last upward pressure in Q1 2024 and then begin a gradual descent. In particular, falling first will be the costs of money market accounts and CDs since they tend to reprice rather quickly with the Fed’s actions.

In general, the composition of MBWM’s deposits has changed for the worse since last year; in fact, non-interest-bearing deposits have gone from being 41% of total deposits to 30%. Be that as it may, the current result remains in line with what MBWM achieved in the pre-pandemic period.

Just as last year, business deposits carry more weight than personal deposits. In any case, both have shifted their liquidity to some type of interest-bearing deposits. Finally, the granularity of deposits remains good as the deposits of the top 57 clients total just $1 billion.

Turning to loans, it is evident that demand for mortgages has dropped given the current interest rates; it has become more difficult for MBWM to originate them. In my opinion, as long as the situation is the same there is not much MBWM can do about it. It will all depend on how quickly the Fed reduces interest rates, but if it does so too quickly it could still be a problem.

As mentioned in the intro, if MBWM is performing well, it is because of the prevalence of variable-rate and not fixed-rate loans. In fact, the former are 71% of total loans while the latter are 29%. This means that while a reduction in the Fed Funds Rate would increase demand for credit, it would also bring significant downward pressure to MBWM’s NIM.

Management is currently discounting two 25 basis point declines, one in July and another in October. This would seem to be the ideal scenario since it would allow a gradual adjustment to MBWM’s loan portfolio. If, however, the decline were to be too fast, the NIM could go way down.

In addition to being variable, most of the loans are short-term since this bank’s main customers are businesses, many of which need to finance working capital:

• 58% will mature within 12 months.
• 26% will mature in 1-5 years.
• Only 16% will mature in 5 years or more.

Unrealized losses and guidance

The plagues of restrictive monetary policy do not stop at the rising cost of funds, but also spread to equity.

Raising the Fed Funds Rate a lot in such a short time generated huge unrealized losses on fixed-rate securities purchased by banks: MBWM is one of many with this problem.

As we can see from this table, the U.S. Gov’t Agency Bonds have an average yield of only 1.29% and as a result are generating most of the unrealized losses, ($52 million). The timing was also wrong for Municipal Bonds, but here the loss is significantly smaller, ($6.20 million).

Be that as it may, despite the unrealized losses MBWM’s financial situation remains stable as shown by this chart. Excess capital manages to cover them remarkably well and will probably continue to do so in the coming quarters. Unless the Fed plans to raise rates again, which no one is predicting at the moment, the unrealized losses are likely to diminish over time as those securities will eventually mature.

Finally, in this quarterly report, management revealed guidance for the full year 2024.

The most interesting aspect here concerns the NIM estimates, between 3.70% – 3.80% (very close to the current 3.92%). As mentioned earlier, management expects two cuts this year, which will bring down asset yields, driven mainly by variable-rate loans ( which is 71 % of total loans). That said, according to management in the second part of 2024 there will be two levers that will prevent an excessive reduction in NIM:

• The first concerns the maturity and subsequent refinancing at lower rates of CDs. The cost of the latter will follow the trend of the Fed Funds Rate.
• The second concerns the maturity of bonds with a very low yield. The proceeds will presumably be reinvested at new market rates; thus, there will be an important spread between the current bonds on the balance sheet yielding 1% – 1.50% and the current bonds that can be purchased in the market.

Finally, during the conference call, management reiterated that there will be no buyback for the time being. The priority is to keep capital ratios high.

Conclusion

MBWM is a solid bank that has managed to navigate even in an extremely complicated macroeconomic environment. Variable rate exposure has made NIM resilient, and according to the guidance it will remain so in 2024. However, it is clear that a faster-than-expected Fed Funds Rate decline will put things in turmoil. Management estimates two rate cuts, perhaps too few compared to what the market expects. Finally, unrealized losses are covered by excess capital and capital ratios remain at good levels.