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Mercantile Bank Corp (NASDAQ:MBWM)
Q3 2020 Earnings Call
Oct 20, 2020, 10:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good morning and welcome to the Mercantile Bank Corporation's Third Quarter 2020 Earnings Results Call and Webcast. [Operator Instructions] Please note, this event is being recorded.

I would now like to turn the conference over to Tyler Deur, from Lambert, Mercantile's Investor Relations firm. Please go ahead.

Tyler Deur -- Investor Relations

Thanks, Hayley. 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 third quarter 2020.

I'm Tyler Deur with Lambert IR, Mercantile's Investor Relations firm. And joining me today are members of their management team, including Bob Kaminski, President and Chief Executive Officer; Chuck Christmas, Executive Vice President and Chief Financial Officer; and Ray Reitsma, President of Mercantile Bank, Michigan.

We'll begin the call with management's prepared remarks and presentation to review the quarter's results, then open up the call to questions. However, before we begin today's call, 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 third quarter 2020 press release and presentation deck issued by Mercantile today, you can access it at the company's website 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?

Robert B. Kaminski Jr. -- President and Chief Executive Officer

Thank you, Tyler, and good morning, everyone. On the call this morning, we will provide you with detailed information on the company's performance in the third quarter amid a challenging operating environment, as well as an update on continued activity specifically related to the pandemic.

First, I again want to recognize the tremendous efforts of our dedicated Mercantile team for their persistent resolve and ongoing ability to navigate the continuous and often unique challenges presented from the pandemic throughout this year.

Our paramount focus has been on the health and safety of our employees, which has created the necessity for flexibility, and our team has consistently risen to the challenge by working remotely and in new environments. These efforts have helped Mercantile deliver strong results of successfully serving our customers and fulfilling their banking needs in a variety of ways.

Mercantile demonstrated continued strength in a number of performance areas for the third quarter, with share earnings of $0.66, which again included a strong provision for loan losses as we continued to build our reserve as a result of pandemic-related issues. This sustained financial strength allowed us to continue our regular cash dividend program with our Board declaring a fourth quarter cash dividend of $0.28 per share.

We are pleased to provide this consistent cash return to our shareholders within this time of uncertainty, and Chuck will provide further updates on the many moving parts in our financial statements during the quarter.

Since the health and safety of our communities is a top priority, our facilities have been updated to incorporate physical and social distancing modifications, including our lobbies, which reopened in late June. Our team and clients remain adaptable for alternative methods of banking activity engagement, as we continue to closely monitor for developments and revise our plans accordingly. The full timeline of COVID-related activities can be viewed on Slide 4 of our presentation.

Our commercial lending team remains focused on the Paycheck Protection Program, as they successfully originated a significant volume of SBA loans for businesses in our markets. Our teams work on the forgiveness phase of the PPP process continues into the fourth quarter as we assist loan recipient clients with gathering and submitting the required information to allow the rendering of a forgiveness determination by the SBA. The efficient efforts of our lending group with PPP have helped to create new relationship opportunities with businesses that face challenges in the application process with the incumbent banks.

Having missed the initial stimulus program needs of these clients and the application process, we are now in a position to grow those relationships through discussions about their full banking needs. Our team's diligence and dedication to our communities is illustrated by our timely and responsive assistance to these businesses as they endeavour to take the needed steps for economic recovery and growth.

We also remain focused on meeting the traditional credit needs of our existing clients while strengthening our pipeline and identifying new customer relationships. Ray will provide you with an update on an overall portfolio performance and the status of customers receiving assistance through our payment deferral programs, which have largely reverted back to full contractual loan payments. As such, our asset quality remains strong and our focus on sound credit underwriting has led to low levels of past due loans and non-performing assets.

With the World Series starting tonight, I want to borrow a baseball term to describe for you that our retail mortgage team knocked the cover off the ball in the third quarter as we achieved another record breaking level of mortgage banking income. The growth of our mortgage lending team in 2020 has allowed their dedicated efforts toward ensuring a strong pipeline, especially during the upcoming months, which reflect normal seasonality.

Within a difficult climate, the team has increased market penetration to enhance revenue and achieve strong residential mortgage loan production levels. Our team puts forth a tremendous effort to ensure the entire loan origination process -- from receipt of an application to closing -- is completed in a structured and timely manner. Ray and Chuck will have more detail on mortgage production in their comments.

Turning to our operations. With the ongoing investment and deployment of technology as alternative delivery channels, which has only been accelerated by the current environment, an evolution in the way banking is done appears to be at hand. Mercantile has been able to reduce its number of locations from 53 to what will be 37 once our recently announced optimization in our branch network is completed later this year. Our current footprint can be viewed on Slide 3.

We continue to engage our customers, so we can take a holistic approach to their needs and understand how patterns and preferences of interaction with us are evolving, especially in view of the realities brought about by COVID-19.

We consistently aim to reevaluate our interactions across the board, conforming to industry best practices while seeking to break new ground across a number of important areas. As we look back on the past two quarters that were so heavily impacted by the pandemic, the health and safety of our people has been paramount. This focus on our people has reinforced our commitment to pursuing best practices in environmental, social, and governance, with particular emphasis on the social component as we work to meet the needs of our stakeholders.

Our Board of Directors, which includes the recently introduced members with diverse business experience, our management team, and our staff remain committed to fulfilling the ever-changing roles as reliable and dedicated community partners and leaders. In addition, we continue to build our internal diversity, equity, and inclusion programs, and have facilitated ongoing meetings, featuring guest speakers we have brought in virtually to provide forums for our employees. Our goal with these programs is to help our team members process and address the issues that have been brought to light in our country and our communities in 2020 regarding racial justice and diversity, equity and inclusion.

We have had ongoing discussion groups within our organization where staff were able to listen and learn about others and provide an opportunity for introspection. We are fervently committed to maintaining these sound corporate practices built on integrity and trust. We're working to diligently cultivate and strengthen our critical relationships with our diverse communities, our employees, our customers, and our shareholders. Together, we have built an incredible foundation that positions us well to sustain and build on these efforts for continued success.

Those are my introductory remarks. I'll now turn it over to Ray.

Raymond E. Reitsma -- Executive Vice President of Mercantile and President of the Bank

Thanks, Bob. Our loan portfolio increased $17 million in the third quarter of 2020, which consisted of a $37 million increase in commercial loans and a $20 million decrease in retail loans, primarily mortgage loans held for sale. The professional manner in which our team administered the origination of over 2,100 PPP loans earlier this year has continued to yield opportunities to grow our base of commercial relationships.

Additionally, our construction pipeline remains solid with $99 million of commitments in commercial construction and development loans, which we expect to fund over the next 12 to 18 months.

Asset quality remained strong as non-performing assets totaled just $4.6 million or 0.11% of total assets as of September 30, 2020. This breakdown can be found in the financial portion of our presentation on Slide 22. Additionally, recurring commercial past due loans at quarter-end are nominal in dollar terms, totaling just $213,000, representing six borrowers. Overall past due information can be found on Slides 11 and 12.

During the quarter, we undertook a review of the risk ratings associated with the loan portfolio, resulting in a provision for loan losses of $3.2 million, pointing adjustments to the risk ratings of 159 specific credits. Even those relationships moved to the watch list.

In contrast, in the prior quarter, the provision expense of $7.6 million is generated entirely through qualitative practices. These actions bring the allowance for losses to total loans to 1.27% when excluding the impact of PPP loans.

Payment deferrals at the peak of the program in mid-July impacted 738 borrowers, represented $719 million in exposure. Presently, as of October 19th, extensions are in place beyond September 30 for peak borrowers, representing $12 million of exposure as seen in Slide 6.

The current modest deferral numbers when combined with our expectations, [Indecipherable] future requests and their strong past due performance are positive indicators. The risk rating process detects a portfolio of strong characteristics, reflecting strengths similar to that of the pre-crisis economy as seen in Slide 10. Maintaining accurate risk ratings will remain a key focus in the upcoming quarters as our borrowers continue to report results impacted by the pandemic.

We continue to monitor the financial condition and performance of credits, particularly in the following segments -- auto dealerships, hotels and lodging, assisted living, restaurants, and movie theatres. None of these individual segments account for more than 5.1% of commercial loans. The composition of these segments can be seen on Slide 9.

We recorded non-interest income during the third quarter of $13.3 million, up $6.6 million or nearly 100% from the prior year quarter. As can be seen on Slide 15, this improved level of non-interest income was largely driven by a 228% increase in mortgage banking income, reflecting the success of ongoing strategic initiatives designed to increase market share, a higher level of refinance activity stemming from historically low rates, and increased share in the purchase market and an increased percentage of loans sold.

For the third quarter of 2020, purchase mortgage loans originated were up 50% over the comparable quarter in the prior year, while refinance activity increased 103% as seen in Slide 8. October applications and backlog suggests that refinance opportunities will persist in the near future and purchase applications are at seasonally high level.

Continuing to enhance mortgage banking income through increased market share, including increased share in the purchase market remains a priority. We will continue to hire proven mortgage loan originators as we are able.

Non-interest income from payroll services grew 8.7%, despite high levels of unemployment during the quarter relative to the prior year comparable quarter. Service charges on accounts decreased 4.2%, primarily due to larger balances offsetting charges. Credit and debit card income increased by approximately 5.7% as activity within the accounts began to recover from reduced activity during the pandemic. The year-to-date activity is approximately equal to last year despite the pandemic-induced reduction in assets [Phonetic].

That concludes my comments. I will now turn the call over to Chuck.

Charles E. Christmas -- Executive Vice President, Chief Financial Officer and Treasurer

Thank you, Ray. As noted on Slide 13, this morning we announced net income of $10.7 million or $0.66 per diluted share for the third quarter of 2020, compared with net income of $12.6 million or $0.77 per diluted share for the third quarter of 2019.

Net income for the first nine months of 2020 totaled $30.1 million or $1.85 per diluted share compared to $36.1 million or $2.20 per diluted share for the first nine months of 2019. Proceeds from bank-owned life insurance claims and a gain on the sale of a former branch facility increased net income in the first nine months of 2019 by $3.1 million or $0.19 per diluted share. Excluding the impacts of these transactions, diluted earnings per share decreased $0.16 or 8% during the first nine months of 2020 compared to the respective prior year period.

The lower levels of net income during the third quarter and first nine months of 2020 compared to the respective 2019 periods resulted from higher provision expense and overhead costs, along with lower net interest income which more than offset increased fee income.

Turning to Slide 14. Interest income on loans declined in the 2020 period compared to the 2019 period, primarily due to FOMC rate cuts aggregating 225 basis points since the beginning of the third quarter of 2019, with 150 basis points of those cuts occurring in the first quarter of 2020. Interest income on securities during the 2020 period benefited from accelerated discount accretion from called U.S. government agency bonds, totaling $0.3 million during the third quarter and $3.0 million during the first nine months of 2020.

In total, interest income declined $4.7 million during the third quarter of 2020 compared to the third quarter of 2019 and was down $8.1 million during the first nine months of 2020 compared to the first nine months of 2019.

Interest expense declined in all categories during the 2020 periods compared to the 2019 periods, reflecting the declining interest rate environment. In total, interest expense declined $2.6 million during the third quarter of 2020 compared to the third quarter of 2019 and was down $5.1 million during the first nine months of 2020 compared to the first nine months of 2019.

Net interest income declined $2.1 million during the third quarter of 2020 compared to the third quarter of 2019 and was down $3.0 million during the first nine months of 2020 compared to the first nine months of 2019.

Provision expense increased significantly in the 2020 periods compared to the 2019 periods, primarily reflecting the coronavirus pandemic and its impact on the economic environment. Provision expense totaled $3.2 million during the third quarter of 2020 and $11.6 million during the first nine months of 2020 compared to $0.7 million and $2.5 million during the respective 2019 periods.

The relatively large provision expense recorded during the third quarter of 2020 was primarily associated with a commercial loan risk rating adjustments Ray mentioned earlier, for the large provision expense recorded during the second quarter of 2020, was primarily comprised of the allocation associated with the newly created COVID-19 pandemic environmental factor and an increased allocation related to the existing economic conditions and environmental factors. The COVID-19 factor was added to address the unique challenges and economic uncertainties resulting from the pandemic and its potential impact on the collectability of loan portfolio.

We elected to postpone the adoption of CECL as permitted by the CARES Act. However, we are running our CECL model concurrently with our incurred loss model. Based on preliminary results, we do not believe the loan loss reserve balance determined by the CECL model is materially different than the loan loss reserve balance as determined by our incurred loss model as of September 30, 2020, similar to the results at the end of the first quarter and second quarter.

Continuing on Slide 15, fee income increased in the 2020 periods compared to the 2019 periods, primarily reflecting significantly higher mortgage banking income. Excluding bank-owned life insurance claims and the gain on the sale of a former branch facility during the first nine months of 2019, fee income during the first nine months of 2020 increased $14.4 million or 88% when compared to the first nine months of 2019.

Reflecting increased refinance and purchase activity, along with the successful implementation of several strategic initiatives over the past couple of years, mortgage banking income was substantially higher during the 2020 periods compared to the 2019 periods. Third quarter 2020 mortgage banking income was $6.6 million higher than the third quarter of 2019 and income during the first nine months of 2020 was $14.5 million higher than the first nine months of 2019.

Credit and debit card income returned to pre-COVID levels during the third quarter, reflecting a recovery in transaction volume in the second quarter. While not quite returning to pre-COVID levels, service charge on account income during the third quarter was much improved in the second quarter, in large part reflecting a higher transaction levels from our business customers.

Continuing on Slide 16, overhead costs increased in the 2020 periods compared to the 2019 periods, primarily reflecting higher compensation cost and the expansion of our main office back in 2019. Salary and benefit costs were up $3.1 million or 22% during the third quarter of 2020 when compared to the third quarter of 2019.

Mortgage banking related compensation costs were up $1.3 million, while the bonus accrual increased $1.2 million. The bonus accrual recorded during the third quarter equated to three quarters worth of accrual as no bonus accruals were recorded during the first and second quarters due to the economic environment.

Salary and benefit costs were up $4.4 million or 11% during the first nine months of 2020 when compared to the first nine months of 2019. Mortgage banking related compensation costs were up $3.7 million while the bonus accruals were essentially the same.

Occupancy, furniture and equipment costs were up a combined $0.6 million during the third quarter of 2020 compared to the third quarter of 2019, and up a combined $1.5 million during the first nine months of 2020 when compared to the first nine months of 2019, in large part reflecting the fall of 2019 completion of our main office expansion. We expect fourth quarter overhead costs to be similar to that of the third quarter. Included in the fourth quarter will be a $1.5 million write down on branches that we are scheduled to close this quarter and being offset by a much lower bonus accrual as there's no catch up involved in the fourth quarter.

Continuing on Slide 17, our net interest margin was 2.86% during the third quarter of 2020, down 31 basis points from the second quarter of 2020 and down 85 basis points when compared to the third quarter of 2019, but it was within the guidance we had provided in the previous call.

The yield on earning assets declined 40 basis points during the third quarter of 2020 when compared to the second quarter of 2020, while the cost of funds declined 9 basis points during the same period. In comparing the third quarter of 2020 with the third quarter of 2019, yield on earning assets declined 128 basis points while the cost of funds declined 43 basis points. The yield on loans was down 15 basis points during the third quarter of 2020 compared to the second quarter of 2020, and down 103 basis points when compared to the third quarter of 2019, in large part reflecting the FOMC's aggregate 225 basis point reduction in targeted federal funds rate mentioned earlier.

We are recording the origination fees and direct origination costs of PPP loans equating to a $15 million net increase to interest income and commercial loans using the level yield method. Third quarter 2020 net accretion totaled $3.0 million. Assuming no forgiveness transactions, we expect to record net accretion of $2.5 million during the fourth quarter of 2020 and $2.1 million, $1.6 million, $1.2 million and $0.8 million during the first, second, third and fourth quarters of 2021, respectively, with the remainder during the first half of 2022.

The yield on securities during the third quarter of 2020 and the first nine months of 2020 benefited from accelerated discount accretion on called U.S. government agency bonds. Accelerated discount accretion totaled $0.3 million during the third quarter of 2020, positively impacting the quarter's net interest margin by 3 basis points. Accelerated discount accretion totaled $3.0 million during the first nine months of 2020, positively impacting the periods net interest margin by 11 basis point.

Negatively impacting our net interest margin during a 2020 period and especially the second and third quarters of 2020, was a significant volume of excess on balance sheet liquidity depicted by low yielding deposits with the Federal Reserve Bank of Chicago and a correspondent bank. The excess funds are primarily a product of federal government stimulus programs as well as lower business and consumer investing and spending.

Overnight deposits averaged $450 million during the third quarter of 2020 and $280 million during the first nine months of 2020 compared to our typical average balance of $50 million to $75 million. We expect a level of overnight deposits to stay at elevated levels for the remainder of 2020 and well into 2021. This excess liquidity lowered our net interest margin during the third quarter of 2020 by about 30 basis points.

The cost of funds has also been on a declining trend, primarily reflecting the falling interest rate environment, but in terms of magnitude and scale, not to the degree experienced on our yield on loans. We currently expect our fourth quarter net interest margin to be in a range of 2.75% to 2.80%; again, that assumes no forgiveness of PPP loans.

As noted on slides 18, 19 and 20, is our mortgage banking income. Mortgage loan originations increased substantially during 2020 periods and especially during the second and third quarters of 2020, in large part reflecting significant refinance activities stemming from the decreased interest rate environment, coupled with the ongoing success of the strategic initiatives that were designed to expand market penetration, enhance gain in activities, and operate more efficiently.

Mortgage loan originations totaled $237 million during the third quarter of 2020 compared to $133 million during the third quarter of 2019, an increase of almost 80%. Mortgage loan originations totaled $646 million during the first nine months of 2020 compared to $258 million during the first nine months of 2019, an increase of about 150%. About 61% of the mortgage volume during the third quarter of 2020 consisted of refinance applications compared to about 53% during the third quarter of 2019. Approximately 81% of the mortgage loan originations during the third quarter of 2020 have been or will be sold on the secondary market, up slightly from the 79% during the third quarter of last year.

Continuing on Slides 21 and 22, a standard quality metrics of the loan portfolio remain very strong, with continued low levels of non-performing loans and loan charge offs. Non-performing loans as a percent of average loans equaled only 12 basis points at September 30, 2020. The balance of other real estate loan was about $500,000 at quarter-end.

Gross loan charge offs totaled only $125,000 during the third quarter of 2020 while recoveries of prior period loan charge offs totaled $250,000. The resulting net loan recoveries of $125,000 equated to 2 basis points of average total loans annualized. Additions to non-performing assets totaled $1.6 million during the third quarter of 2020, with a net increase of $1.2 million recorded in non-performing assets during the quarter.

Over the past 12 months, the balance of our loan loss reserve has increased by over $11 million or about 45% with the coverage ratio excluding PPP loans growing from 88 basis points to 1.27%.

Capital, as shown on Slide 23, we remain in a strong and well capitalized regulatory capital position. The Tier 1 leverage capital ratio was 9.8% and the total risk-based capital ratio was 13.8% as at quarter-end. The total risk-based capital ratio was over $126 million above the minimum threshold to be categorized as well capitalized.

There was no share repurchase activity during the third quarter of 2020. As in late March, we elected to temporarily cease share repurchase activity to preserve capital for lending and other purposes due to the uncertainties surrounding the COVID-19 pandemic. We currently have about $10 million available in our repurchase plan.

On Slide 24, and to conclude my remarks, are some comments on the 2021. Due to the high degree of uncertainty that currently exists, we will not be providing earnings performance guidance as we have done on past conference calls. However, we are able to offer key considerations that should be factored into any earnings forecast of our company.

Clearly, economic conditions, asset quality, PPP forgiveness activity, and mortgage banking operations are expected to have the most impact on our operating results for the remainder of this year and into 2021.

In closing, while uncertainties remain that may impact Mercantile's financial condition and operating performance in future periods, we note that we entered this stress environment with strong asset quality and a solid capital position. We are pleased with our third quarter operating results and financial condition as of September 30, 2020 and believe we are well-positioned to navigate through the unprecedented environment created by the coronavirus pandemic and other events.

Those are my prepared remarks. I'll now turn the call back over to Bob.

Robert B. Kaminski Jr. -- President and Chief Executive Officer

Thank you, Chuck. That now concludes management's prepared comments, and we will open the call to the Q&A.

Questions and Answers:

Operator

We'll now begin the question-and-answer session. [Operator Instructions] Our first question today comes from Brendan Nosal with Piper Sandler.

Brendan Nosal -- Piper Sandler -- Analyst

Hey, good morning, everybody. How are you?

Robert B. Kaminski Jr. -- President and Chief Executive Officer

Good, Brendan. How are you?

Brendan Nosal -- Piper Sandler -- Analyst

Great. Thanks. Just want to start off on the margin here -- and thanks for all the puts and takes you guys offered in your prepared remarks. Just thinking back to the last quarter's call, I believe that you said the expectation for the margin with a normal level of liquidity and PPP forgiveness was about 3.10% to 3.15%. Just curious if this is a decent expectation once liquidity does eventually roll off to more typical level or is there more pressure from that figure from what you thought previously?

Charles E. Christmas -- Executive Vice President, Chief Financial Officer and Treasurer

Yes, Brendan, I think there might have been some miscommunication because the numbers you just quoted excluded the excess liquidity. So, that was the difference between what we actually reported and that calculation. So, one of the things we saw in the balance sheet during the third quarter was everything pretty much was steady from where it was at the end of the second quarter. So -- and part of that was our excess liquidity position. We ended the second quarter soon thereafter with about $450 million on deposit with the Fed and a correspondent bank. It was pretty much that average throughout the quarter and that's pretty much where we're at right now.

So, a lot of stabilization there, which is good; but certainly, a tremendous amount of excess liquidity that we certainly don't need. Clearly, we would like our borrowers and our depositors start using those funds, if anything from a macro standpoint to make sure that the economy continues to recover. But it appears that we're in a state of steadiness, and at least so far here and three weeks into the fourth quarter, we haven't seen any change in our balance sheet structure.

So, in looking at our margin for the fourth quarter compared to where it came in in the third quarter, we are expecting some slippage there, two main items there or three main items, I guess. Certainly, the bigger one would be the reduction in PPP loan fees that we're going to record. Again, we're using a level yield method, so that goes down over time and I gave you those numbers.

We did have -- one of the things we don't really budget for are any prepayment fees. We typically get those every quarter, but those are very difficult to predict. So, we really don't predict those. And then the -- our methodology of trying to manage interest rate risk with our bond portfolio, whereby we buy heavily discounted bonds during periods of rising interest rates, a vast majority of those bonds have now been called. So, we don't really expect much of that to take place in future quarters, including the fourth quarter. So, those are the three primary items that get us from a margin of being in the mid-2.80s to maybe mid-2.70s.

Brendan Nosal -- Piper Sandler -- Analyst

Got it. That's perfect. And totally understood that the first figure I quoted excludes any impact on excess liquidity. Perfect.

Just one more from me. Hoping you can offer a little bit more color on the credit downgrades that drove the provision this quarter, just kind of any top level thoughts on industry concentrations or characteristics, etc.? And then as you look ahead, are there any more credits that are on your short list for more downgrades or do this quarter's action pretty much true up the risk ratings to what the environment is today?

Raymond E. Reitsma -- Executive Vice President of Mercantile and President of the Bank

This is Ray. Your last question, definitely as we made these downgrades, we feel like we completed the job. We try to even look ahead and say, are there any in the fourth quarter that could potentially give us issues? And we downgraded those as well. So, we feel like, based on all the information that we have today, we completed that job, and also worked hard at all the credits that had requested and experienced deferrals in their payments and went through those very carefully. About 45% of those showed no change in risk rating. We downgraded about 40% of those, one notch; and the balance, which is a relatively small number, another 14%, another notch. So, we feel like all the information that's available to evaluate our credits are taken into account and we've downgraded everyone that we see having some small issues now or anticipate having issues in the next quarter.

Robert B. Kaminski Jr. -- President and Chief Executive Officer

Yes, this is Bob. Just to amplify that, we had a definite plan as we went through the summer months. Our intention when the pandemic first started and the severe economic shutdowns was occurring, that we weren't just going to have a knee jerk reaction and downgrade the portfolio without some empirical data from our clients and financial statements and do it in a very systematic way. That occurred during the summer, into the fall; and as Ray indicated, concluded with the end of the third quarter. And we feel really good about where we stand working with our clients, knowing exactly where they are in terms of their economic recovery, and any challenges that remain ahead for them. But to underscore, we feel really good about the status of the portfolio and the reserve and the associated grades with those particular credits.

Brendan Nosal -- Piper Sandler -- Analyst

All right. Fantastic. Thank you for taking the questions.

Robert B. Kaminski Jr. -- President and Chief Executive Officer

Thank you.

Operator

[Operator Instructions]. Our next question today comes from Damon DelMonte with KBW.

Damon DelMonte -- KBW -- Analyst

Hey, good morning, guys. How's it going today?

Robert B. Kaminski Jr. -- President and Chief Executive Officer

Good day, Damon. How are you?

Damon DelMonte -- KBW -- Analyst

Good. Thanks. So, first question, just wanted to clarify, Chuck, in your comments regarding expenses, you said you expected fourth quarter to be similar to the third quarter. And then you also noted that there would be about $1.5 million of a write down on the branch closures that are taking effect here in the fourth quarter. Does that -- is that $1.5 million included in that outlook for a relatively flat quarter-over-quarter basis or is that excluding it?

Charles E. Christmas -- Executive Vice President, Chief Financial Officer and Treasurer

So, that includes it, Damon. So, on an overall basis, we expect the cost to be flat. Included in that is the $1.5 million in write downs that we'll be recording throughout the quarter as the branches close. But as I also mentioned, with the bonus accrual, we did not accrue anything in the first and second quarter because of obviously the pandemic. As we work our way through the year and we see our performance and as we talk with our compensation committee, we are in the process of formally formulating bonus plans. And based on those discussions and our calculations, we needed to not only accrue for the third quarter, but we needed to catch up for the first and second quarter.

So, on an overall basis, those two items -- so, a lower bonus calculation in the fourth quarter compared to the third kind of offsets the $1.5 million expected in write downs on the branches.

Damon DelMonte -- KBW -- Analyst

Got you. Okay. So, well, just make sure I'm clear on this. So then, something like around 20 -- a little bit over $25 million then is reasonable?

Charles E. Christmas -- Executive Vice President, Chief Financial Officer and Treasurer

So, it would be the same as the third quarter, Damon.

Damon DelMonte -- KBW -- Analyst

Okay, OK. Would be -- OK, OK. It's interesting that they offset perfectly. Okay.

Charles E. Christmas -- Executive Vice President, Chief Financial Officer and Treasurer

Yes.

Damon DelMonte -- KBW -- Analyst

And then I guess with respect to the PPP forgiveness process, what are your thoughts and what are you guys hearing on timing of this? Do you think -- we are kind of well into the fourth quarter here, do you think we're going to see much forgiveness in the fourth quarter or do you think everything is going to kind of be -- with the election coming up next month and whatever ensues after that, do you think this is all going to kind of be put on hold until we get into 2021?

Raymond E. Reitsma -- Executive Vice President of Mercantile and President of the Bank

Yes, this is Ray. It is very hard to predict how that process is going to go. We stand ready to act on whatever guidance and actionable items we get from the SBA. And those have been somewhat sparse today. How those will roll out for the remainder of the quarter, very hard to predict. But the bottom line is, we'll be ready as soon as practical, as soon as that information is available to us.

We have the mechanisms in place electronically to deal with that information. We also have people in place to deal with the information. So, we are ready and waiting.

Robert B. Kaminski Jr. -- President and Chief Executive Officer

We've actually started the submission process, working with our clients, providing them with the tools, as Ray said, to be able to make those submissions for their forgiveness. Some customers are still working through that process with their financial advisors on the accounting side and their legal side to make sure that documentation is in order. But through our electronic portal, we've now started the submissions to the government. Have not received any responses yet, but we understand that they've got a lot that they're trying to work through on their end from the SBA standpoint. So, as Ray said already, we're very transparent with our clients and available to assist the process toward its conclusion for each client.

Charles E. Christmas -- Executive Vice President, Chief Financial Officer and Treasurer

You know, well -- this is Chuck, and I will just add my two cents. One of the things that the entire banking industry has been waiting on is the expedited process that we're all hoping with the trade groups, trying to get $150,000 lower. It appears that it will be at a $50,000 lower clip. And while the SBA has provided some guidelines, they have not yet opened their portals up to accepting those specific applications. That represents about 45%, so loans under $50,000 represents about 45% in the number of loans on the 2,100 that we originated under PPP.

Damon DelMonte -- KBW -- Analyst

Well, OK. Great. And then -- so, to make sure I'm reading this correctly, your loan deferrals are now down to like 43 basis points alone, only $12 million, correct?

Charles E. Christmas -- Executive Vice President, Chief Financial Officer and Treasurer

Correct.

Damon DelMonte -- KBW -- Analyst

Okay. So, how do we think about provision going forward? It sounds like this quarter you adjusted the ratings on some and you kind of built up some additional reserving as a result of those indicators. Do you think you go back to a similar level in the fourth quarter or do you think you can even go lower than that in the fourth quarter, kind of absent any major macro changes?

Charles E. Christmas -- Executive Vice President, Chief Financial Officer and Treasurer

Yes, Damon, I mean, it's an interesting perspective that you're putting on and we're looking at it ourselves. Really there's -- we kind of did that with the second and third quarter. There's really two key drivers, right? There's the environmentals and then there's the specific downgrades. And we hit the environmentals really hard in the second quarter, obviously created, as we mentioned, the COVID-19 factor. Our economic factors is as low as it can go. The COVID factor could theoretically have additional downgrade to it, which would cause some additional provision, and that is a reminder that factor was designed to be the -- we don't know what's going to happen factor. And, so far, obviously we look at our asset quality and we're certainly pleased with the performance so far. But it appears that we're far away from being out of the woods yet. So, that factor we will certainly continue to take a look at.

The other factors that we haven't touched yet, which are the traditional factors that the regulators gave us years and years ago, trends and past dues, changes in collateral values, those types of things. Things are holding up pretty steady so far. But clearly, at the end of the fourth quarter here and going forward, of course, we'll continue to look at those and change those if need be.

I think Ray and Bob already kind of did a really good job of explaining what we did with the downgrades in the third quarter. So, kind of putting all that together as we sit here today and see what's going on, we feel really good about where our reserve is, but we're certainly going to continue to look at all those factors. And if we need to downgrade loans, we'll downgrade loans. If we need to change some factors, environmental factors, we'll do that. But all things being equal, we're pretty comfortable with where we're at currently.

Damon DelMonte -- KBW -- Analyst

Got it. Okay. That's all that I have for now. Thank you very much, guys.

Robert B. Kaminski Jr. -- President and Chief Executive Officer

Thank you, Damon.

Operator

[Operator Instructions]. And it looks like we have a follow-up question from Damon DelMonte with KBW.

Robert B. Kaminski Jr. -- President and Chief Executive Officer

I think you must have pressed star Damon.

Damon DelMonte -- KBW -- Analyst

I did. Well, nobody else is in the queue. I figured I could get a couple more questions while I had the opportunity.

Robert B. Kaminski Jr. -- President and Chief Executive Officer

Well, that is so kind of you.

Damon DelMonte -- KBW -- Analyst

I don't like to get off that easy. No, just kidding. With regards to capital, can you give a little perspective on where the shares are trading today and the possible use of capital to do a buyback or even look to raise some additional sub debt to kind of bolster regulatory ratios to maybe facilitate buyback down the road, kind of what are your thoughts around that?

Robert B. Kaminski Jr. -- President and Chief Executive Officer

I think there are tugs and pulls in all different directions, Damon, as you have kind of alluded to with many banks, many companies issuing some sub debt, and some other banks thinking about dipping their toe in the water back with buybacks. But I think as we continue to consult with our Board and look at our numbers, we're taking a steady as she goes approach. I think as Chuck indicated in his comments, the buybacks we've -- we're sitting on the sidelines right now, but we'll continue to evaluate that and make sure that -- with the stock price being what it is, that we don't miss any opportunities that we might otherwise take.

So, it's kind of a balancing act to make sure that we're good stewards of our capital and position us for whatever may come down the pipe in 2021 in terms of economic challenges or opportunities to deploy that capital. We want to make sure that we're well positioned to be able to handle whatever that can be thrown at us and take advantage of opportunities in the same manner. So, I think we continue to evaluate that from quarter-to-quarter and look and see where we stand. But right now, we're quite comfortable where we're at.

Damon DelMonte -- KBW -- Analyst

Got it. Okay, that's good. And then I guess just last question, just quickly on mortgage banking, could you just give a quick update on your pipelines here in the fourth quarter and kind of how you think that shapes up for the actual fourth quarter result?

Charles E. Christmas -- Executive Vice President, Chief Financial Officer and Treasurer

Yes, typically in the fourth quarter, there is a seasonal decline in the mortgage business. And as we observe our pipeline over the very recent past, that has not shown any of those classic signs of a seasonal decline. So, it may very well come toward the very end of the year, but in the next month or two, we expect it to hold up at similar levels to what we've experienced in the last month or so.

Robert B. Kaminski Jr. -- President and Chief Executive Officer

Just anecdotally, Damon, still when you look at houses as they pop on the market, considering that we're almost in November, just from my neck of the woods in the Kent County area of Grand Rapids, the houses are on the market very long before they're snatched up and purchased by prospective new homeowners. So, the market continues strong, as Ray alluded to, and it's going to be interesting winter months. But I think because of the fact that the spring season was pushed back because of the shutdowns of the pandemic, I think it could create some interesting volume opportunities for us as we go through the winter of 2020 and 2021.

Damon DelMonte -- KBW -- Analyst

Okay, very helpful. This time, that's all that I have. So, thank you very much.

Robert B. Kaminski Jr. -- President and Chief Executive Officer

Thanks, Damon. Take care.

Operator

This concludes our question-and-answer session. And I would like to turn the call back over to Bob Kaminski for any closing remarks.

Robert B. Kaminski Jr. -- President and Chief Executive Officer

Thank you, operator. Thank you very much for your interest in our company. We hope that you and your families stay safe and healthy, and we look forward to speaking with you again at the conclusion of the fourth quarter come January. This call is now concluded. Thanks again.

Operator

[Operator Closing Remarks]

Duration: 49 minutes

Call participants:

Tyler Deur -- Investor Relations

Robert B. Kaminski Jr. -- President and Chief Executive Officer

Raymond E. Reitsma -- Executive Vice President of Mercantile and President of the Bank

Charles E. Christmas -- Executive Vice President, Chief Financial Officer and Treasurer

Brendan Nosal -- Piper Sandler -- Analyst

Damon DelMonte -- KBW -- Analyst

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