Good morning, and welcome to the Mercantile Bank Corporation Q1 2021 Earnings Results Conference Call. All participants will be in a listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star then one on your telephone keypad. To withdraw your question, please press star then two. 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.
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 Q1 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 to questions. Before turning the call over to management, it is my responsibility to inform you that this call may involve certain forward-looking statements such as projections of revenue, earnings, and capital structure, as well as statements on the plans and objectives of the company's business.
The company's actual results could differ materially from any forward-looking statements made today due to 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 Q1 2022 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 would like to turn the call over to Mercantile's President and Chief Executive Officer, Bob 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 Q1 , as well as updates on the current operating environment. We are pleased to begin the year with a solid Q1 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 Q1 , we reported net income of $11.5 million or 73 cents 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, when 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 Q1 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 staffs. Accordingly, in February, we implemented a $1 per hour wage increase for all non-exempt 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 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 adroitly managed through the challenges over the past two years since the onset of the COVID-19 pandemic. We expect they will continue to do so in 2022. 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 turn the call over to Ray.
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 Q1 , 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 and 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 totals $184 million. Secondly, strategic diversity and sustainable non-interest income.
For the Q1 , we are 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 masked 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 a 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 3 basis points of non-performing assets at the end of the Q1 of 2022, compared to $0.4 million of ORE and 7 basis points of 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 Q1 , compared to $0.3 million in the comparable period last year. That concludes my comments. I will now turn the call over to Chuck.
Thanks, Ray, and 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 Q1 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 in 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 results in refinance activity.
Turning to slide 25, interest income on loans during the Q1 of 2022 increased $0.3 million from the year-ago Q1 as growth in core commercial loans and residential mortgage loans offset lower PPP net loan fee income accretion. Interest income on securities in the Q1 of 2022 increased $0.6 million from the Q1 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 of funds on deposit with the Federal Reserve Bank of Chicago, increased $0.2 million during the Q1 of 2022 compared to the year ago Q1 , primarily reflecting increased balances. In total, interest income for the most recent quarter increased $1.1 million from the Q1 of 2021. Interest expense on deposits during the Q1 of 2022 decreased $0.9 million from the year ago Q1 as lower deposit rates more than offset increased interest-bearing deposit balances.
Interest expense on other borrowed money in the Q1 of 2022 increased $0.8 million from the Q1 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 Q1 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 interest-earning assets decreased 27 basis points, primarily reflecting a decline in loan yields associated with lower PPP net fee 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 cost of funds declined 7 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 the 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 programs, as well as lower business and consumer investing and spending.
Overnight deposits averaged $784 million during the Q1 of 2022 compared to $592 million during the Q1 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 Q1 of 2022 and all of 2021 by about 40-45 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 bank's regulatory capital ratios were augmented this past December and January with an aggregate $90 million issuance of subordinated notes, of which a vast majority of the funds were downstreamed 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 Q1 . We did not repurchase shares during the Q1 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 to 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.
Thank you, Chuck. That concludes management's prepared comments, and we'll now open the call to the question and answer period.
Thank you. We will now begin the question and answer session. To ask a question, you may press star then one on your telephone keypad. If you are using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press star then two. At this time, we will pause momentarily to assemble our roster. The first question will come from Brendan Nosal with Piper Sandler. Please go ahead.
Hey, good morning, folks. How are you doing?
Good, Brendan.
Good. Good morning.
Good. Maybe just to start off on kind of the NII outlook you provided on slide 32. I do get that, you know, part of the NIM expansion that you're forecasting is, you know, 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 kind of curious, how much of that margin improvement do you think is really a function of rates moving higher?
I think, you know, most of the expected increase is from the rates, but we are expecting, you know, 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, you know, we expect loan growth to be somewhat similar for the remainder of this year as to what it was in the Q1 . But you can see that average earning assets are trending downward at least for the next couple quarters before it flattens out. Of course, what that is really a net of the loan growth less the expected runoff of some of our excess liquidity.
Yeah. That makes perfect sense. Okay, good. Maybe one more from me just on the expense outlook. Costs obviously fell, you know, quite a bit from the Q1 as comp accruals reset, which was certainly nice to see. I guess just, you know, going forward in that, the outlook you provide for expenses, is it safe to assume that includes accruals for, you know, what is appearing to be a good NII outlook given rate increases?
Yes. Yep. That takes into account, you know, what we think the rates are gonna do, you know, for the rest of this year and the associated impact on our overhead costs for the remainder of the year.
All right. Wonderful. Thank you for taking the questions.
Thank you.
The next question will come from Daniel Tamayo with Raymond James. Please go ahead.
Morning, guys.
Good morning.
Maybe just starting on the loan growth. You know, you just talked about that, you know, that guidance kind of remaining similar to what we saw in the Q1 , which is great. Q1 had a little more 1one-four family growth than I was expecting. Can you just talk about what the type of mix of growth you're expecting going forward, and if there was anything unusual in the Q1 ?
Yeah. 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 to 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 bit less on balance sheet growth with our residential mortgage loan portfolio. 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.
It's kind of more of a balance there. Definitely the trend is there for additional growth, and we're looking for ways to maybe mitigate that.
I'd supplement that point with the fact that construction mortgages have become more popular, roughly twice as high as the previous quarter. 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.
Okay. Great. Switching gears here to the fee income and, you know, appreciate you guys putting guidance on that last slide. That's very helpful. Within the fee income, you know, obviously mortgage banking took a big hit in the quarter, and you talked about the refi versus purchase dynamics a little bit. Can you give what the gain on sale rate was in the quarter, and what the change was from last year or the Q4 , and if there was any MSR change in that number as well?
I think on the gain rate, we're going to probably have to get back to you, Dan, and 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 lower of cost or market, so there's no fair value adjusting going on there. You know, we certainly continue to see some acceleration from some refinance activity. Clearly, we see a decline in refinance activity. Accelerated amortization of mortgage servicing rights is slowing down. We would expect that to continue to slow down, which of course would be a tailwind for mortgage banking income as we go forward.
Clearly, the production and especially the volume of sold versus portfolio is going to be a bigger player on that number.
Just kind of bigger picture, you know, the number came, you know, the run rate, if you will, I guess, came way down in the quarter. You know, you've talked about the focus on growing the purchase side. You know, is this the new run rate that you're still expecting that would come down as refi volumes decline, you know, from that 3.3 million number? You know, how are you thinking about where you might end up in a normalized environment in terms of volumes, at least?
I'll give you a general answer, and I'll let Chuck follow up with the specifics. You know, seasonally here in Michigan, we do expect a pickup in activity as we move from the Q1 into the Q2, and the Q2 and the Q3 are seasonally strong for us here in the lovely state of Michigan. It's weather-driven, school-driven like it is everywhere else. We would expect to see some recovery there from a seasonal pattern that's in evidence every year.
I think as we also mentioned, another factor into the mix is the limited supply of homes that are available for sale. As I mentioned in my comments, Daniel, many customers who would just as soon 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 it takes a little bit longer, too. As Ray hit on that number, we've seen a significant increase in our construction commitments here in the Q1 . 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.
They're looking at all options, but a lot of dynamics in the market right now affecting consumers' decisions. I think, Daniel, this is Chuck again, if I could add to that is when you look at our fee income performance for the Q1 , you know, apart from the mortgage banking, we think that the trends that you saw in the Q1 will continue for the rest of the year. 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. The big wild card as we're talking here and trying to answer your question as best we can is mortgage banking.
There's just so many moving parts to it that you know it becomes somewhat difficult to try to narrow that down. You know we're very very pleased with our mortgage operation. You know clearly us and the industry certainly enjoyed very very strong refinance activity over the last two calendar years and other attributes as well including you know pretty high gain rates in the marketplace. But with the increase in mortgage rates you know the refi area is drying up pretty significantly. Reliance on purchase you know is going to become a bigger and bigger issue.
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. 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 the last couple of years. But I think as Ray mentioned, we saw really solid growth in the purchase volume that we've got 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, you know, a higher volume.
I would dare say that we believe that we've increased our market penetration and it's just in a different market.
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 the close volume. They're up, you know, like 25% over what they were last year at this time. Similarly, the apps for refinance are down in that 60% range. If you move from what's closed to what we anticipate closing based on applications in process, yes, the trend will continue.
I think looking at our mortgage production for the Q1 , those numbers are pretty much on track with what we were expecting for the Q1 . The main difference is the percentage of loans that we're selling and the mix of the type of loans that we're generating leaning towards construction. 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. That's terrific, Tyler. I really appreciate that, particularly as it relates to the, you know, the impact on our loan growth and the construction side. That's all I have. Appreciate it, guys.
You're welcome.
Thank you. The next question will be from Damon DelMonte with KBW. Please go ahead.
Hey, good morning, guys. How's everybody doing today?
Morning, Damon. How are you?
Doing great, thanks. First question, I just want to talk a little bit about loan growth. You know, you guys sound pretty optimistic on the commercial side of things. You know, do you think that kind of keeping the commercial growth rate at that, you know, high single-digit to low double-digit range is doable for the remainder of the year? Or do you think it kind of comes back to more of the mid- to upper-single-digit range?
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 Q1 . As we look at our backlogs, opportunities, and all the surrounding information, it appears that the immediate future looks a lot like the past.
Thank you, Ray.
I would add, you know, the unknown that we have, and of course we had some in the Q1 , is the payoffs. When we look at our pipelines and all the trends, we definitely see a lot of momentum there, and believe we'll hit on that. It's just a matter of the payoffs that come in as borrowers, you know, sell their projects or the underlying assets. That's the unknown on trying to factor in, commercial loan growth.
Got it. Is there any particular region of your footprint or area of your footprint that is showing better opportunity than others?
Not particularly. You know, Grand Rapids is always a strong market for us. We're very well represented here by our commercial loan team and, you know, long history of participating in that market. They're all fairly robust.
Got it. Okay. All right. That's great. Then on the credit side, you know, you guys finally adopted CECL as of 1/1/2022. You know, you had a modest adjustment to your reserve level. Chuck, can you help us just think a little bit about, you know, 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?
This is the new normal.
You're gonna make me talk about CECL this morning, aren't you? You know, clearly, you know, the loan growth necessitates additional reserves. While we don't like making provisions, we certainly, you know, want to make sure we keep our reserve adequate, which is reflective of that loan growth. Of course, you know, we're very proud of our 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, you know, you're heavily relying on your qualitative measurements and those factors.
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 Q1 , it's kind of more of a, to answer your question in a very long-winded way, it's more about what happens with those qualitative factors. You know, the big one, of course, which is pretty much out of our control, is the economic forecast, as we use a third party and look to market for that. You know, 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 also as of the end of March, there's actually a small negative to our reserve calculation on the economic factor. You know, we would expect that probably as we move along that, you know, 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, you know, that impacts any bank that's, you know, adopted CECL. I would also say, you know, 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 you know, all the impacts that it has, supply chains and all those things that we know about. You know, there's quite a bit of money in the reserve for that factor. You know, hopefully over time we can start peeling some of that away. Definitely look forward to that. Then, of course, we'll just keep an eye on all the other normal regulatory factors that we have. I can't give you a solid answer. I think that right now, what we saw in the Q1 seems to be you know, what I would expect in at least the next couple quarters. But that makes the assumption that there's no significant change in economic forecasting.
I will add that just pure commercial loan growth in and 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.
Yeah. It's you know, and that's one of the reasons why we delayed CECL as long as we could because we know it to be a duration-based model. We're obviously a commercial bank with a duration of barely over two years. 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. We have to deal with that. Then therefore, you have a lot more reliance on environmental factors on the commercial side to support some higher reserve dollars.
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. You know, 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?
Yeah, 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 Q1 . There's, you know, the ongoing costs associated with that. Yeah, as always, when you look at the makeup of our overhead, it's salaries and benefits, and it's data processing costs that are the big numbers, and changes in those are gonna be the primary drivers of any changes in our overhead costs.
Got it. Okay. That's all that I had. Thank you very much, guys. Appreciate it.
Thanks, Damon.
The next question will be from Bryce Rowe from Hovde Group. Please go ahead.
Thanks. Good morning, guys. How are you?
Morning.
Morning.
I appreciate all the kind of detail and 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? Are you thinking about, you know, each subsequent rate hike any differently from a deposit beta perspective?
Yeah. Bryce, you know, that's a great question because of all the things that we talked about, mortgage banking, some others, that's difficult to forecast. Deposits are just there. You know, obviously, all the banks, including Mercantile, have seen significant deposit growth over the last couple of years. We don't think it's all gonna stay. We think a fair amount of it's gonna stay. But when the money starts, you know, when the balances start leaving, you know, they're starting to be invested, starting to be spent, or whatnot, that, of course, plays into the margin calculation and excess funding and all that type of thing. You know, we have to have some expectations for that. I would say so far, we've seen very little in the way of deposit withdrawals.
As a matter of fact, you know, 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 did happen this year. It's seasonal for us. If you exclude the one withdrawal from the large depositor that made a large deposit at the end of last year, we actually saw a net deposit growth here in the Q1 . In a quarter that we generally see a reduction in deposits, we actually saw more growth. 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.
What we don't see is a lot of money changing banks. You know, the rates are still 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, you 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. It also, the demand for the deposits has a big play as well.
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. You know, we're surmising here, but rates are very, very low, and I think a lot of depositors 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 will probably become more attentive to what's being paid on deposits.
You know, perhaps that will put some pressure on us as a market, as an industry, to have to raise deposit rates as we move forward. To the degree that they're gonna move going forward is kind of really anybody's guess. On the assumptions that I provided on our forecast ideas and thoughts that I provided, we kind of use more of our historical betas, which are probably more aggressive. You know, clearly, we want to be somewhat conservative in putting out our expectations. They're relatively aggressive because we're using historical numbers. I use those consistently throughout the rest of the year.
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. That's kind of our thoughts, is that we'll probably eventually come out at an average of betas. 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.
That's perfect. Thanks, Chuck.
You're welcome.
Once again, if you have a question, please press star then one. The next question will be from John Rodis from Janney. Please go ahead.
Good morning, everybody.
Morning.
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 to down going forward given the outlook for loan growth?
Yeah. I think I have a little bit of an increase in that portfolio, John, but I don't think it's nothing material. What you see in the average earning assets is the security staying relatively stable. The growth in loans, as we've talked about, and then the net is the reduction in excess funding.
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?
They were performance difficulties, largely related to the industry they were in relative to the pandemic environment. I believe one was hospitality, one was an entertainment venue, obviously impacted by the environment. Their performance during that particular time was depressed.
Okay. Ray, do you see more exposure there or, you know, as it relates to those industries and stuff that would give you pause?
Not at this point. We feel pretty good about our remaining portfolio. Our watch list is at a low point historically. Most of those types of credits have performed quite well of late.
Okay. Fair enough. Thank you, guys.
You're welcome, John. Thank you.
Ladies and gentlemen, this concludes our question and answer session. I would like to turn the conference back over to Bob Kaminski for any closing remarks.
Well, thank you very much for your interest in our company. We look forward to speaking with you next at the end of the Q2 . This call is concluded.
Thank you, sir. The conference has now concluded. Thank you for attending today's presentation. You may now disconnect your lines.