News Column

MERCANTILE BANK CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

August 8, 2014

Forward Looking Statements

This report contains forward-looking statements that are based on management's beliefs, assumptions, current expectations, estimates and projections about the financial services industry, the economy, and our company. Words such as "anticipates," "believes," "estimates," "expects," "forecasts," "intends," "is likely," "plans," "projects," and variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions ("Future Factors") that are difficult to predict with regard to timing, extent, likelihood and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed or forecasted in such forward-looking statements. We undertake no obligation to update, amend, or clarify forward looking-statements, whether as a result of new information, future events (whether anticipated or unanticipated), or otherwise. Future Factors include, among others, changes in interest rates and interest rate relationships; demand for products and services; the degree of competition by traditional and non-traditional competitors; changes in banking regulation or actions by bank regulators; changes in tax laws; changes in prices, levies, and assessments; our ability to successfully integrate the operations of Mercantile and Firstbank and their respective subsidiary banks; the ability of the combined company to compete in the highly competitive banking and financial services industry; the impact of technological advances; governmental and regulatory policy changes; the outcomes of contingencies; trends in customer behavior as well as their ability to repay loans; changes in local real estate values; changes in the national and local economies; and risk factors described in our annual report on Form 10-K for the year ended December 31, 2013 or in this report. These are representative of the Future Factors that could cause a difference between an ultimate actual outcome and a forward-looking statement. Introduction The following discussion compares the financial condition of Mercantile Bank Corporation and its consolidated subsidiaries, including Mercantile Bank of Michigan ("our bank") and our bank's two subsidiaries, Mercantile Bank Real Estate Co., LLC ("our real estate company") and Mercantile Insurance Center, Inc. ("our insurance company"), at June 30, 2014 and December 31, 2013 and the results of operations for the three months and six months ended June 30, 2014 and June 30, 2013. This discussion should be read in conjunction with the interim consolidated financial statements and footnotes included in this report. Unless the text clearly suggests otherwise, references in this report to "us," "we," "our" or "the company" include Mercantile Bank Corporation and its consolidated subsidiaries referred to above.



Critical Accounting Policies

Accounting principles generally accepted in the United States of America are complex and require us to apply significant judgment to various accounting, reporting and disclosure matters. We must use assumptions and estimates to apply these principles where actual measurements are not possible or practical. Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our unaudited financial statements included in this report. For a discussion of our significant accounting policies, see Note 1 of the Notes to our Consolidated Financial Statements included on pages F-48 through F-53 in our Form 10-K for the fiscal year ended December 31, 2013 (Commission file number 000-26719). Our allowance for loan losses policy and accounting for income taxes are highly dependent upon subjective or complex judgments, assumptions and estimates. Changes in such estimates may have a significant impact on the financial statements, and actual results may differ from those estimates. We have reviewed the application of these policies with the Audit Committee of our Board of Directors. --------------------------------------------------------------------------------



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-------------------------------------------------------------------------------- Allowance for Loan Losses: The allowance for loan losses ("allowance") is maintained at a level we believe is adequate to absorb probable incurred losses identified and inherent in the loan portfolio. Our evaluation of the adequacy of the allowance is an estimate based on past loan loss experience, the nature and volume of the loan portfolio, information about specific borrower situations and estimated collateral values, guidance from bank regulatory agencies, and assessments of the impact of current and anticipated economic conditions on the loan portfolio. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in our judgment, should be charged-off. Loan losses are charged against the allowance when we believe the uncollectability of a loan is likely. The balance of the allowance represents our best estimate, but significant downturns in circumstances relating to loan quality or economic conditions could result in a requirement for an increased allowance in the future. Likewise, an upturn in loan quality or improved economic conditions may result in a decline in the required allowance in the future. In either instance, unanticipated changes could have a significant impact on the allowance and operating results. The allowance is increased through a provision charged to operating expense. Uncollectable loans are charged-off through the allowance. Recoveries of loans previously charged-off are added to the allowance. A loan is considered impaired when it is probable that contractual interest and principal payments will not be collected either for the amounts or by the dates as scheduled in the loan agreement. Impairment is evaluated in aggregate for smaller-balance loans of similar nature such as residential mortgage, consumer and credit card loans, and on an individual loan basis for other loans. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan's existing rate or at the fair value of collateral if repayment is expected solely from the collateral. The timing of obtaining outside appraisals varies, generally depending on the nature and complexity of the property being evaluated, general breadth of activity within the marketplace and the age of the most recent appraisal. For collateral dependent impaired loans, in most cases we obtain and use the "as is" value as indicated in the appraisal report, adjusting for any expected selling costs. In certain circumstances, we may internally update outside appraisals based on recent information impacting a particular or similar property, or due to identifiable trends (e.g., recent sales of similar properties) within our markets. The expected future cash flows exclude potential cash flows from certain guarantors. To the extent these guarantors provide repayments, a recovery would be recorded upon receipt. Loans are evaluated for impairment when payments are delayed, typically 30 days or more, or when serious deficiencies are identified within the credit relationship. Our policy for recognizing income on impaired loans is to accrue interest unless a loan is placed on nonaccrual status. We put loans into nonaccrual status when the full collection of principal and interest is not expected. Income Tax Accounting: Current income tax assets and liabilities are established for the amount of taxes payable or refundable for the current year. In the preparation of income tax returns, tax positions are taken based on interpretation of federal and state income tax laws for which the outcome may be uncertain. We periodically review and evaluate the status of our tax positions and make adjustments as necessary. Deferred income tax assets and liabilities are also established for the future tax consequences of events that have been recognized in our financial statements or tax returns. A deferred income tax asset or liability is recognized for the estimated future tax effects attributable to temporary differences that can be carried forward (used) in future years. The valuation of our net deferred income tax asset is considered critical as it requires us to make estimates based on provisions of the enacted tax laws. The assessment of the realizability of the net deferred income tax asset involves the use of estimates, assumptions, interpretations and judgments concerning accounting pronouncements, federal and state tax codes and the extent of future taxable income. There can be no assurance that future events, such as court decisions, positions of federal and state tax authorities, and the extent of future taxable income will not differ from our current assessment, the impact of which could be significant to the consolidated results of operations and reported earnings. --------------------------------------------------------------------------------



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-------------------------------------------------------------------------------- Accounting guidance requires that we assess whether a valuation allowance should be established against our deferred tax assets based on the consideration of all available evidence using a "more likely than not" standard. In making such judgments, we consider both positive and negative evidence and analyze changes in near-term market conditions as well as other factors which may impact future operating results. Significant weight is given to evidence that can be objectively verified. During 2011, we returned to pre-tax profitability for four consecutive quarters. Additionally, we experienced lower provision expense, continued declines in nonperforming assets and problem asset administration costs, a higher net interest margin, a further strengthening of our regulatory capital ratios and additional reductions in wholesale funding. This positive evidence allowed us to conclude that, as of December 31, 2011, it was more likely than not that we returned to sustainable profitability in amounts sufficient to allow for realization of our deferred tax assets in future years. Consequently, we reversed the valuation allowance that we had previously determined necessary to carry against our entire net deferred tax asset starting on December 31, 2009. Securities and Other Financial Instruments: Securities available for sale consist of bonds and notes which might be sold prior to maturity due to changes in interest rate, prepayment risks, yield and availability of alternative investments, liquidity needs or other factors. Securities classified as available for sale are reported at their fair value. Declines in the fair value of securities below their cost that are other than temporary are reflected as realized losses. In estimating other than temporary losses, management considers: (1) the length of time and extent that fair value has been less than carrying value? (2) the financial condition and near term prospects of the issuer? and (3) the Company's ability and intent to hold the security for a period of time sufficient to allow for any anticipated recovery in fair value. Fair values for securities available for sale are obtained from outside sources and applied to individual securities within the portfolio. The difference between the amortized cost and the current fair value of securities is recorded as a valuation adjustment and reported in other comprehensive income. Mortgage Servicing Rights: Mortgage servicing rights are recognized as assets based on the allocated fair value of retained servicing rights on loans sold. Servicing rights are carried at the lower of amortized cost or fair value and are expensed in proportion to, and over the period of, estimated net servicing income. We utilize a discounted cash flow model to determine the value of our servicing rights. The valuation model utilizes mortgage prepayment speeds, the remaining life of the mortgage pool, delinquency rates, our cost to service loans, and other factors to determine the cash flow that we will receive from serving each grouping of loans. These cash flows are then discounted based on current interest rate assumptions to arrive at the fair value of the right to service those loans. Impairment is evaluated quarterly based on the fair value of the servicing rights, using groupings of the underlying loans classified by interest rates. Any impairment of a grouping is reported as a valuation allowance. Goodwill: Generally accepted accounting principles require us to determine the fair value of all of the assets and liabilities of an acquired entity, and record their fair value on the date of acquisition. We employ a variety of means in determination of the fair value, including the use of discounted cash flow analysis, market comparisons, and projected future revenue streams. For certain items that we believe we have the appropriate expertise to determine the fair value, we may choose to use our own calculation of the value. In other cases, where the value is not easily determined, we consult with outside parties to determine the fair value of the asset or liability. Once valuations have been adjusted, the net difference between the price paid for the acquired company and the value of its balance sheet is recorded as goodwill. --------------------------------------------------------------------------------



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-------------------------------------------------------------------------------- Goodwill results from business acquisitions and represents the excess of the purchase price over the fair value of acquired tangible assets and liabilities and identifiable intangible assets. Goodwill is assessed at least annually for impairment and any such impairment is recognized in the period identified. A more frequent assessment is performed if conditions in the market place or changes in the company's organizational structure occur. We use a discounted income approach and a market valuation model, which compares the inherent value of our company to valuations of recent transactions in the market place to determine if our goodwill has been impaired.



Firstbank Merger

We completed the merger of Firstbank Corporation ("Firstbank"), a Michigan corporation with approximately $1.5 billion in total assets and 46 branch locations, into Mercantile Bank Corporation as of June 1, 2014 ("Merger Date"). The results of operations due to the Firstbank transaction have been included in Mercantile's financial results since the Merger Date. All of Firstbank's common stock was converted into the right to receive one share of Mercantile common stock for each share of Firstbank common stock. The conversion of Firstbank's common stock into Mercantile's common stock resulted in Mercantile issuing 8,087,272 shares of its common stock. In conjunction with the completion of the merger, Mercantile assumed the obligations of four business trusts that were formed by Firstbank to issue trust preferred securities. The Firstbank transaction was accounted for using the acquisition method of accounting and accordingly, assets acquired, liabilities assumed and consideration exchanged were recorded at estimated fair value on the Merger Date. In accordance with the applicable accounting guidance for business combinations, these fair values are preliminary and subject to refinement for up to one year after the closing date of the transaction as additional information relative to closing date fair value may become available. In most instances, determining the fair value of the acquired assets and assumed liabilities required us to estimate cash flows expected to result from those assets and liabilities and to discount those cash flows at appropriate rates of interest. The most significant of those determinations relates to the valuation of acquired loans. For such loans, the excess of cash flows expected at acquisition over the estimated fair value is recognized as interest income over the remaining lives of the loans. The difference between contractually required payments at acquisition and the cash flows expected to be collected at acquisition reflects the impact of estimated credit losses and other factors, such as prepayments. In accordance with the applicable accounting guidance for business combinations, there was no carry-over of Firstbank's previously established allowance for loan losses. The acquired loans were divided into loans with evidence of credit quality deterioration, which are accounted for under ASC 310-30 ("acquired impaired"), and loans that do not meet this criteria, which are accounted for under ASC 310-20 ("acquired non-impaired"). Our operating results for the quarter ended June 30, 2014 include the operating results of the acquired assets and assumed liabilities for the 30 days subsequent to the Merger Date. The operations of the former Firstbank organization provided approximately $4.5 million in net interest income for the period from the Merger Date to June 30, 2014, and are included in our consolidated financial statements for the three and six month periods ending June 30, 2014. Firstbank's results of operations prior to the Merger Date are not included in our consolidated statements of income or comprehensive income. We recorded merger-related expenses of $3.5 million and $3.8 million during the three month and six month periods ended June 30, 2014, respectively. Such expenses were generally for professional services, costs related to termination of existing contractual arrangements for various services, retention and severance compensation costs, marketing and promotional expenses, travel costs, and printing and supplies costs. Virtually all of Mercantile and Firstbank's operating systems are now integrated. --------------------------------------------------------------------------------



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Financial Overview

We reported net income of $1.5 million, or $0.13 per diluted share, for the second quarter of 2014, and net income of $5.1 million, or $0.50 per diluted share, during the first six months of 2014.

Our second quarter and year-to-date earnings results were significantly impacted by the Firstbank merger. In addition to our earnings results reflecting one month of operations as a combined organization, we recorded relatively large merger-related costs during the first six months of 2014, primarily during the second quarter. Merger-related costs totaled $3.5 million during the second quarter and $3.8 million during the first six months of 2014. On an after-tax basis, that equated to $2.4 million, or $0.21 per diluted share, during the second quarter, and $2.7 million, or $0.27 per diluted share, during the first six months of 2014. We expect to record additional merger-related costs during the next several quarters, although we expect future costs to be considerably lower than the amounts expensed during the second quarter. The quality of our loan portfolio continues to improve, which when combined with recoveries of prior loan charge-offs and the eliminations of and reductions in specific reserves, have produced a positive impact on our allowance calculations and allowed us to make negative provisions in six consecutive quarters and in eight of the last nine quarters. We have recorded a net loan recovery during the past five consecutive quarters and during seven out of the last nine quarters. The improvement in the quality of the loan portfolio and reductions in foreclosed asset balances have also resulted in significantly lower problem asset administration costs. In fact, when gains on the sale of foreclosed assets are netted against problem asset administration costs, we recorded a slightly negative net expense during both the first and second quarters of 2014. New term loan originations totaled approximately $75 million during the second quarter of 2014 and about $121 million during the first six months of 2014. We have also experienced net increases in commercial lines of credit, in large part reflecting lines that are part of new commercial lending relationships established during recent quarterly periods. Our loan portfolio is well diversified post-merger, with commercial and industrial loans comprising 30% of total loans, commercial real estate non-owner occupied loans equaling 27%, and commercial real estate owner occupied along with residential mortgage and consumer loans both at 19% of total loans. As a percent of total commercial loans, commercial and industrial loans and commercial real estate owner occupied loans equal 59%. The merger with Firstbank also had a significant positive impact on our funding structure, resulting in a well diversified funding mix. Noninterest-bearing checking accounts comprise 21% of total funds, interest-bearing checking and sweep accounts combine for 22%, savings deposits and money market accounts aggregate to 24% and local time deposits account for 23%. Wholesale funds, comprised of brokered deposits and FHLB advances, represent 10% of total funds. Financial Condition Primarily reflecting the merger with Firstbank, our total assets increased $1.45 billion during the first six months of 2014, and totaled $2.88 billion as of June 30, 2014. Total loans increased $1.02 billion and securities available for sale were up $344 million, while cash and cash equivalents decreased $28.1 million. Total deposits increased $1.18 billion and securities sold under agreements to repurchase ("repurchase agreements") were up $54.8 million during the first six months of 2014.

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-------------------------------------------------------------------------------- Our loan portfolio has historically been primarily comprised of commercial loans, although less so now with the Firstbank merger. Commercial loans increased $701 million during the first six months of 2014, and at June 30, 2014 totaled $1.69 billion, or 81.4% of the loan portfolio. As of December 31, 2013, the commercial loan portfolio comprised 93.7% of total loans. The increase in commercial loans during the first six months of 2014 includes about $121 million in new commercial term loans to existing and new borrowers, with the remainder generally reflecting the Firstbank merger. Commercial and industrial loans were up $330 million, non-owner occupied commercial real estate ("CRE") loans increased $185 million, owner occupied CRE loans increased $123 million, multi-family and residential rental loans increased $47 million and vacant land, land development and residential construction loans were up $17 million. As a percent of total commercial loans, commercial and industrial loans and commercial real estate owner occupied loans equal 59%. We significantly enhanced our commercial loan sales efforts over the past couple of years. We are very pleased with the approximately $525 million in new commercial term loan fundings since the beginning of 2012, and our current pipeline reports indicate continued strong commercial loan funding opportunities in future periods. Also, as of June 30, 2014, availability on existing construction and development loans totaled over $51 million, with most of those funds expected to be drawn over the next twelve months. In addition, we have made additional lending commitments totaling about $177 million, a majority of which we expect to be accepted and funded over the next 12 to 18 months. Our commercial lenders also report substantial additional opportunities they are currently discussing with existing and potentially new borrowers. We continue to experience some commercial loan principal paydowns and payoffs. A majority of these principal paydowns and payoffs received thus far have been welcomed, such as on stressed loan relationships; however, we have also experienced instances where well-performing relationships have been refinanced at other financial institutions and other situations where the borrower has sold the underlying asset, paying off the loan. In many of those cases where the loans were refinanced elsewhere, we believed the terms and conditions of the new lending arrangements were too aggressive, generally reflecting the very competitive banking environment in our markets. We remain committed to prudent underwriting standards that provide for an appropriate yield and risk relationship. In addition, we continue to receive accelerated principal paydowns from certain borrowers who have elevated deposit balances generally resulting from profitable operations and an apparent unwillingness to expand their businesses and/or replace equipment primarily due to economic- and tax-related uncertainties. Usage of existing commercial lines of credit has remained relatively steady. Reflecting the Firstbank merger, one-to-four family mortgage loans increased $185 million and other consumer loans were up $135 million during the first six months of 2014, and at June 30, 2014, totaled a combined $386 million, or 18.6% of total loans. One-to-four family mortgage loans and other consumer loans equated to 6.3% of total loans as of December 31, 2013. --------------------------------------------------------------------------------



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-------------------------------------------------------------------------------- The following table summarizes our loan portfolio at June 30, 2014, broken out by loans originated by Mercantile and loans acquired in the Firstbank merger: Originated Acquired Total Loans Loans Loans Commercial: Commercial & Industrial $ 342,375,000$ 273,684,000$ 616,059,000



Land Development & Construction 32,214,000 21,091,000

53,305,000

Owner Occupied Commercial RE 264,596,000 119,818,000



384,414,000

Non-Owner Occupied Commercial RE 399,855,000 149,434,000

549,289,000

Multi-Family & Residential Rental 37,569,000 47,099,000

84,668,000 Total Commercial 1,076,609,000 611,126,000 1,687,735,000 Retail: 1-4 Family Mortgages 33,337,000 182,702,000 216,039,000 Home Equity & Other Consumer 35,151,000 134,557,000 169,708,000 Total Retail 68,488,000 317,259,000 385,747,000 Total $ 1,145,097,000$ 928,385,000$ 2,073,482,000 Our credit policies establish guidelines to manage credit risk and asset quality. These guidelines include loan review and early identification of problem loans to provide effective loan portfolio administration. The credit policies and procedures are meant to minimize the risk and uncertainties inherent in lending. In following these policies and procedures, we must rely on estimates, appraisals and evaluations of loans and the possibility that changes in these could occur quickly because of changing economic conditions. Identified problem loans, which exhibit characteristics (financial or otherwise) that could cause the loans to become nonperforming or require restructuring in the future, are included on an internal watch list. Senior management and the Board of Directors review this list regularly. Market value estimates of collateral on impaired loans, as well as on foreclosed and repossessed assets, are reviewed periodically; however, we have a process in place to monitor whether value estimates at each quarter-end are reflective of current market conditions. Our credit policies establish criteria for obtaining appraisals and determining internal value estimates. We may also adjust outside and internal valuations based on identifiable trends within our markets, such as recent sales of similar properties or assets, listing prices and offers received. In addition, we may discount certain appraised and internal value estimates to address distressed market conditions. Nonperforming assets, comprised of nonaccrual loans and foreclosed properties, totaled $8.6 million (0.3% of total assets) as of June 30, 2014, compared to $9.6 million (0.7% of total assets) as of December 31, 2013. The volume of nonperforming assets has generally been on a declining trend since the peak of $117.6 million on March 31, 2010, and is currently at its lowest level since year-end 2006. Reductions in nonperforming assets during the first six months of 2014 primarily reflect principal payments on nonaccrual loans and sales proceeds on foreclosed properties. Foreclosed properties acquired in the Firstbank merger totaled $1.2 million. Acquired loans are recorded at fair value with no allowance brought forward in accordance with acquisition accounting. Acquired impaired loans are considered performing due to the application of the accretion method under acquisition accounting. --------------------------------------------------------------------------------



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-------------------------------------------------------------------------------- The following tables provide a breakdown of nonperforming assets by collateral type: NONPERFORMING LOANS 6/30/14 3/31/14 12/31/13 9/30/13 6/30/13

Residential Real Estate: Land Development $ 36,000$ 38,000$ 40,000$ 43,000$ 317,000 Construction 0 0 0 0 0 Owner Occupied / Rental 3,898,000 4,026,000 4,219,000 2,859,000 3,201,000 3,934,000 4,064,000 4,259,000 2,902,000 3,518,000 Commercial Real Estate: Land Development 235,000 361,000 389,000 627,000 650,000 Construction 0 0 0 0 0 Owner Occupied 1,176,000 784,000 885,000 718,000 960,000 Non-Owner Occupied 129,000 335,000 169,000 3,251,000 4,642,000 1,540,000 1,480,000 1,443,000 4,596,000 6,252,000 Non-Real Estate: Commercial Assets 267,000 798,000 1,016,000 1,111,000 755,000 Consumer Assets 0 0 0 0 1,000 267,000 798,000 1,016,000 1,111,000 756,000 Total $ 5,741,000$ 6,342,000$ 6,718,000$ 8,609,000$ 10,526,000 OTHER REAL ESTATE OWNED & REPOSSESSED ASSETS 6/30/14 3/31/14 12/31/13 9/30/13 6/30/13 Residential Real Estate: Land Development $ 427,000$ 427,000$ 427,000$ 495,000$ 619,000 Construction 22,000 22,000 22,000 89,000 89,000 Owner Occupied / Rental 968,000 186,000 207,000 219,000 315,000 1,417,000 635,000 656,000 803,000 1,023,000 Commercial Real Estate: Land Development 92,000 92,000 92,000 6,000 31,000 Construction 0 0 0 0 0 Owner Occupied 300,000 75,000 164,000 501,000 606,000 Non-Owner Occupied 1,069,000 1,548,000 1,939,000 2,239,000 2,256,000 1,461,000 1,715,000 2,195,000 2,746,000 2,893,000 Non-Real Estate: Commercial Assets 0 0 0 0 0 Consumer Assets 0 0 0 0 0 0 0 0 0 0 Total $ 2,878,000$ 2,350,000$ 2,851,000$ 3,549,000$ 3,916,000

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The following tables provide a reconciliation of nonperforming assets:

NONPERFORMING LOANS RECONCILIATION 2nd Qtr 1st Qtr 4th Qtr 3rd Qtr 2nd Qtr 2014 2014 2013 2013 2013 Beginning balance $ 6,342,000$ 6,718,000$ 8,609,000$ 10,526,000$ 12,395,000 Additions, net of transfers to ORE (11,000 ) 174,000 1,734,000 502,000 438,000 Principal payments (523,000 ) (449,000 ) (3,072,000 ) (2,363,000 ) (1,988,000 ) Loan charge-offs (67,000 ) (101,000 ) (553,000 ) (56,000 ) (319,000 ) Total $ 5,741,000$ 6,342,000$ 6,718,000$ 8,609,000$ 10,526,000 OTHER REAL ESTATE OWNED & REPOSSESSED ASSETS RECONCILIATION 2nd Qtr 1st Qtr 4th Qtr 3rd Qtr 2nd Qtr 2014 2014 2013 2013 2013 Beginning balance $ 2,350,000$ 2,851,000$ 3,549,000$ 3,916,000$ 6,505,000 Additions - originated loans 175,000 0 134,000 350,000 57,000 Additions - merger ORE 1,187,000 0 0 0 0 Sale proceeds (790,000 ) (501,000 ) (797,000 ) (527,000 ) (2,374,000 ) Valuation write-downs (44,000 ) 0 (35,000 ) (190,000 ) (272,000 ) Total $ 2,878,000$ 2,350,000$ 2,851,000$ 3,549,000$ 3,916,000 During the first six months of 2014, loan charge-offs totaled $0.7 million while recoveries of prior period charge-offs aggregated to $1.3 million, resulting in a net recovery $0.6 million. We recorded a net recovery of prior period charge-offs of $1.3 million during all of 2013. --------------------------------------------------------------------------------



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-------------------------------------------------------------------------------- The following table provides a breakdown of net loan charge-offs (recoveries) by collateral type: 2nd Qtr 1st Qtr 4th Qtr 3rd Qtr 2nd Qtr 2014 2014 2013 2013 2013

Residential Real Estate: Land Development $ (4,000 )$ (1,000 )$ (78,000 )$ (387,000 )$ (119,000 ) Construction 0 0 0 0 0 Owner Occupied / Rental (572,000 ) (139,000 ) (144,000 ) (105,000 ) (301,000 ) (576,000 ) (140,000 ) (222,000 ) (492,000 ) (420,000 ) Commercial Real Estate: Land Development (11,000 ) 0

0 0 30,000 Construction 0 0 0 0 0 Owner Occupied 98,000 37,000 47,000 (74,000 ) (6,000 ) Non-Owner Occupied (70,000 ) 336,000



1,206,000 (1,215,000 ) 79,000

17,000 373,000



1,253,000 (1,289,000 ) 103,000

Non-Real Estate: Commercial Assets (45,000 ) (267,000 ) (1,154,000 ) (172,000 ) (95,000 ) Consumer Assets 2,000 1,000 (4,000 ) 5,000 1,000 (43,000 ) (266,000 ) (1,158,000 ) (167,000 ) (94,000 ) Total $ (602,000 )$ (33,000 ) $



(127,000 ) $ (1,948,000 )$ (411,000 )

In each accounting period, we adjust the allowance to the amount we believe is necessary to maintain the allowance at an adequate level. Through the loan review and credit departments, we establish portions of the allowance based on specifically identifiable problem loans. The evaluation of the allowance is further based on, but not limited to, consideration of the internally prepared Allowance Analysis, loan loss migration analysis, composition of the loan portfolio, third party analysis of the loan administration processes and portfolio, and general economic conditions. The Allowance Analysis applies reserve allocation factors to non-impaired outstanding loan balances, the result of which is combined with specific reserves to calculate an overall allowance dollar amount. For non-impaired commercial loans, reserve allocation factors are based on the loan ratings as determined by our standardized grade paradigms and by loan purpose. Our commercial loan portfolio is segregated into five classes: 1) commercial and industrial loans; 2) vacant land, land development and residential construction loans; 3) owner occupied real estate loans; 4) non-owner occupied real estate loans; and 5) multi-family and residential rental property loans. The reserve allocation factors are primarily based on the historical trends of net loan charge-offs through a migration analysis whereby net loan losses are tracked via assigned grades over various time periods, with adjustments made for environmental factors reflecting the current status of, or recent changes in, items such as: lending policies and procedures; economic conditions; nature and volume of the loan portfolio; experience, ability and depth of management and lending staff; volume and severity of past due, nonaccrual and adversely classified loans; effectiveness of the loan review program; value of underlying collateral; loan concentrations; and other external factors such as competition and regulatory environment. Adjustments for specific lending relationships, particularly impaired loans, are made on a case-by-case basis. Non-impaired retail loan reserve allocations are determined in a similar fashion as those for non-impaired commercial loans, except that retail loans are segmented by type of credit and not a grading system. We regularly review the Allowance Analysis and make needed adjustments based upon identifiable trends and experience. --------------------------------------------------------------------------------



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-------------------------------------------------------------------------------- A migration analysis is completed quarterly to assist us in determining appropriate reserve allocation factors for non-impaired commercial loans. Our migration analysis takes into account various time periods, with most weight placed on a twelve-quarter time frame. We believe the twelve-quarter period represents an appropriate range of economic conditions, and that it provides for an appropriate basis in determining reserve allocation factors given current economic conditions and the general consensus of economic conditions in the near future. Although the migration analysis provides a historical accounting of our net loan losses, it is not able to fully account for environmental factors that will also very likely impact the collectability of our commercial loans as of any quarter-end date. Therefore, we incorporate the environmental factors as adjustments to the historical data. Environmental factors include both internal and external items. We believe the most significant internal environmental factor is our credit culture and the relative aggressiveness in assigning and revising commercial loan risk ratings, with the most significant external environmental factor being the assessment of the current economic environment and the resulting implications on our commercial loan portfolio. The primary risk elements with respect to commercial loans are the financial condition of the borrower, the sufficiency of collateral, and timeliness of scheduled payments. We have a policy of requesting and reviewing periodic financial statements from commercial loan customers, and we have a disciplined and formalized review of the existence of collateral and its value. The primary risk element with respect to each residential real estate loan and consumer loan is the timeliness of scheduled payments. We have a reporting system that monitors past due loans and have adopted policies to pursue creditor's rights in order to preserve our collateral position. The allowance equaled $20.9 million as of June 30, 2014, or 1.8% of total originated loans outstanding, compared to 2.2% as of December 31, 2013. A large portion of the decline in the level of the allowance during the first six months of 2014 reflects elimination and reduction of specific reserves due to successful collection efforts, while the remainder of the decline is primarily associated with commercial loan upgrades and reductions in most reserve allocation factors on non-impaired commercial loans resulting from the impact of lower net loan charge-offs in recent periods on our migration calculations. The allowance equaled 363.3% of nonperforming loans as of June 30, 2014, compared to 339.7% as of December 31, 2013. This particular allowance measurement has increased significantly during the past several years primarily due to total nonperforming loans declining at a faster rate than the balance of the allowance and certain accruing higher-balance commercial loan relationships having been categorized as troubled debt restructurings resulting in higher specific reserve allocations. As of June 30, 2014, the allowance was comprised of $10.5 million in general reserves relating to non-impaired loans, $1.5 million in specific reserve allocations relating to nonaccrual loans, and $8.9 million in specific reserves on other loans, primarily accruing loans designated as troubled debt restructurings. Troubled debt restructurings totaled $29.1 million at June 30, 2014, consisting of $4.2 million that are on nonaccrual status and $24.9 million that are on accrual status. The latter, while considered and accounted for as impaired loans in accordance with accounting guidelines, is not included in our nonperforming loan totals. Impaired loans with an aggregate carrying value of $2.4 million as of June 30, 2014 had been subject to previous partial charge-offs aggregating $2.4 million. Those partial charge-offs were recorded as follows: $0.1 million during the first six months of 2014, $0.5 million in 2013, $1.1 million in 2012, $0.5 million in 2011 and $0.2 million in 2010. As of June 30, 2014, there were no specific reserves allocated to impaired loans that had been subject to a previous partial charge-off. --------------------------------------------------------------------------------



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-------------------------------------------------------------------------------- The following table provides a breakdown of our loans categorized as troubled debt restructurings: 6/30/14 3/31/14 12/31/13 9/30/13 6/30/13 Performing $ 24,901,000$ 27,093,000$ 30,247,000$ 41,707,000$ 42,991,000 Nonperforming 4,232,000 4,800,000 4,645,000 5,782,000 7,523,000 Total $ 29,133,000$ 31,893,000$ 34,892,000$ 47,489,000$ 50,514,000



Although we believe the allowance is adequate to absorb loan losses in our originated loan portfolio as they arise, there can be no assurance that we will not sustain loan losses in any given period that could be substantial in relation to, or greater than, the size of the allowance.

Reflecting the merger with Firstbank, securities increased $344 million during the first six months of 2014, totaling $475 million as of June 30, 2014. Purchases during the first six months of 2014, consisting almost exclusively of U.S. Government agency bonds, totaled $11.7 million. Proceeds from matured and called U.S. Government agency bonds and municipal bonds during the first six months of 2014 totaled $11.0 million and $7.8 million, respectively, with another $3.9 million from principal paydowns on mortgage-backed securities. At June 30, 2014, the portfolio was primarily comprised of U.S. Government agency bonds (45%), municipal bonds (32%) and U.S. Government agency issued or guaranteed mortgage-backed securities (23%). All of our securities are currently designated as available for sale, and are therefore stated at fair value. The fair value of securities designated as available for sale at June 30, 2014 totaled $475 million, including a net unrealized loss of $4.2 million. We maintain the securities portfolio at levels to provide adequate pledging and secondary liquidity for our daily operations. In addition, the securities portfolio serves a primary interest rate risk management function. FHLB stock totaled $19.2 million as of June 30, 2014, an increase of $7.3 million from the balance at December 31, 2013 resulting from the Firstbank merger. Our investment in FHLB stock is necessary to engage in their advance and other financing programs. We have received regularly quarterly cash dividends, and we expect a cash dividend will continue to be paid in future quarterly periods. Market values on our U.S. Government agency bonds, mortgage-backed securities issued or guaranteed by U.S. Government agencies and municipal bonds are generally determined on a monthly basis with the assistance of a third party vendor. Evaluated pricing models that vary by type of security and incorporate available market data are utilized. Standard inputs include issuer and type of security, benchmark yields, reported trades, broker/dealer quotes and issuer spreads. We believe our valuation methodology provides for a reasonable estimation of market value, and that it is consistent with the requirements of accounting guidelines. Federal funds sold, consisting of excess funds sold overnight to a correspondent bank, along with investments in interest-bearing deposits at correspondent and other banks, are used to manage daily liquidity needs and interest rate sensitivity. During the first six months of 2014, the average balance of these funds equaled $93.2 million, or 6.1% of average earning assets. We expect the level of these funds to average approximately 1% to 2% of average earning assets in future quarters. Net premises and equipment equaled $49.0 million at June 30, 2014, an increase of $24.1 million during the first six months of 2014. The merger with Firstbank accounts for virtually the entire increase. --------------------------------------------------------------------------------



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-------------------------------------------------------------------------------- Foreclosed and repossessed assets totaled $2.9 million at June 30, 2014, unchanged from the balance at December 31, 2013. Foreclosed property sales totaled $1.3 million during the first six months of 2014, while foreclosed properties from the Firstbank merger totaling $1.2 million were added during the period. While we expect some transfers from loans to foreclosed and repossessed assets in future periods reflecting our collection efforts on impaired lending relationships, we expect that sales activity will limit any increase in, and average balance of, this nonperforming asset category. Primarily reflecting the merger with Firstbank, total deposits increased $1.18 billion during the first six months of 2014, totaling $2.30 billion at June 30, 2014. Out-of-area deposits decreased $25.3 million during the first six months of 2014, and as a percent of total deposits, equaled 8.2% as of June 30, 2014, compared to 19.0% as of December 31, 2013. Noninterest-bearing checking accounts increased $291 million during the first six months of 2014. While the growth is primarily due to the Firstbank merger, noninterest-bearing checking accounts also increased due to deposit account openings as part of new commercial lending relationships. Also reflecting the impact of the Firstbank merger, interest-bearing checking accounts increased $227 million, money market deposit accounts grew $104 million, savings deposits increased $289 million and local time deposits grew $298 million during the first six months of 2014. Repurchase agreements increased $54.8 million during the first six months of 2014, totaling $124 million as of June 30, 2014. The increase is primarily due to the merger with Firstbank. As part of our sweep account program, collected funds from certain business noninterest-bearing checking accounts and savings deposits are invested into over-night interest-bearing repurchase agreements. Such repurchase agreements are not deposit accounts and are not afforded federal deposit insurance. Reflecting the merger with Firstbank, FHLB advances increased $12.0 million during the first six months of 2014. As of June 30, 2014, FHLB advances totaled $57.0 million. The FHLB advances are collateralized by residential mortgage loans, first mortgage liens on multi-family residential property loans, first mortgage liens on commercial real estate property loans, and substantially all other assets of our bank, under a blanket lien arrangement. Our borrowing line of credit as of June 30, 2014 totaled about $570 million, with availability approximating $509 million. Liquidity Liquidity is measured by our ability to raise funds through deposits, borrowed funds, and capital, or cash flow from the repayment of loans and securities. These funds are used to fund loans, meet deposit withdrawals, maintain reserve requirements and operate our company. Liquidity is primarily achieved through local and out-of-area deposits and liquid assets such as securities available for sale, matured and called securities, federal funds sold and interest-bearing balances. Asset and liability management is the process of managing our balance sheet to achieve a mix of earning assets and liabilities that maximizes profitability, while providing adequate liquidity. To assist in providing needed funds, we have regularly obtained monies from wholesale funding sources. Wholesale funds, primarily comprised of deposits from customers outside of our market areas and advances from the FHLB, totaled $245 million, or 9.9% of combined deposits and borrowed funds, as of June 30, 2014, compared to $258 million, or 20.9% of combined deposits and borrowed funds, as of December 31, 2013.

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-------------------------------------------------------------------------------- As part of our sweep account program, collected funds from certain business noninterest-bearing checking accounts and savings deposits are invested into over-night interest-bearing repurchase agreements. Such repurchase agreements are not deposit accounts and are not afforded federal deposit insurance. Repurchase agreements increased $54.8 million during the first six months of 2014, totaling $124 million as of June 30, 2014. The increase is primarily attributable to the merger with Firstbank. Information regarding our repurchase agreements as of June 30, 2014 and during the first six months of 2014 is as follows: Outstanding balance at June 30, 2014 $



124,108,000

Weighted average interest rate at June 30, 2014 0.10 % Maximum daily balance six months ended June 30, 2014 $



126,621,000

Average daily balance for six months ended June 30, 2014 $



79,003,000

Weighted average interest rate for six months ended June 30, 2014

0.12 % As a member of the FHLB, we have access to the FHLB advance borrowing programs. FHLB advances increased $12.0 million during the first six months of 2014, reflecting the merger with Firstbank. As of June 30, 2014, FHLB advances totaled $57.0 million. Based on available collateral at June 30, 2014, we could borrow an additional $509 million. We also have the ability to borrow up to $63.0 million on a daily basis through correspondent banks using established unsecured federal funds purchased lines of credit. We did not access these lines of credit during first six months of 2014; in fact, we have not accessed the lines of credit since January of 2010. In contrast, federal funds sold averaged $86.9 million during the first six months of 2014. We have a line of credit through the Discount Window of the Federal Reserve Bank of Chicago. Using certain municipal bonds as collateral, we could have borrowed up to $12.4 million as of June 30, 2014. We did not utilize this line of credit during the first six months of 2014 or at any time during the previous five fiscal years, and do not plan to access this line of credit in future periods. The following table reflects, as of June 30, 2014, significant fixed and determinable contractual obligations to third parties by payment date, excluding accrued interest: One Year One to Three to Over or Less Three Years Five Years Five Years Total Deposits without a stated maturity $ 1,519,730,000 $ 0 $ 0 $ 0 $ 1,519,730,000 Certificates of deposit 382,018,000 287,746,000 113,767,000 0 783,531,000 Short-term borrowings 124,108,000 0 0 0 124,108,000 Federal Home Loan Bank advances 9,000,000 23,044,000 25,000,000 0 57,044,000 Subordinated debentures 0 0 0 54,131,000 54,131,000 Other borrowed money 9,545,000 1,455,000 0 3,348,000 14,348,000 Property leases 301,000 614,000 532,000 195,000 1,642,000

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-------------------------------------------------------------------------------- In addition to normal loan funding and deposit flow, we must maintain liquidity to meet the demands of certain unfunded loan commitments and standby letters of credit. As of June 30, 2014, we had a total of $595 million in unfunded loan commitments and $37.6 million in unfunded standby letters of credit. Of the total unfunded loan commitments, $418 million were commitments available as lines of credit to be drawn at any time as customers' cash needs vary, and $177 million were for loan commitments generally expected to close and become funded within the next twelve months. We regularly monitor fluctuations in loan balances and commitment levels, and include such data in our overall liquidity management. We monitor our liquidity position and funding strategies on an ongoing basis, but recognize that unexpected events, changes in economic or market conditions, a reduction in earnings performance, declining capital levels or situations beyond our control could cause liquidity challenges. While we believe it is unlikely that a funding crisis of any significant degree is likely to materialize, we have developed a comprehensive contingency funding plan that provides a framework for meeting liquidity disruptions.



Capital Resources

Shareholders' equity was $316 million at June 30, 2014, compared to $153 million at December 31, 2013. The $163 million increase during the first six months of 2014 was primarily due to the merger with Firstbank. We issued 8,087,272 shares of common stock, valued at $173 million, in connection with the merger. Net income during the first six months of 2014 totaled $5.1 million. Negatively impacting shareholder's equity during the first six months of 2014 were cash dividends on common shares totaling $20.4 million. In accordance with the plan of merger with Firstbank, we declared and paid a special $2.00 per share cash dividend to Mercantile shareholders prior to the effective date of the merger and before the issuance of Mercantile shares in exchange for Firstbank shares. In addition, we declared and paid a $0.12 per share cash dividend in both the first and second quarters of 2014. We and our bank are subject to regulatory capital requirements administered by state and federal banking agencies. Failure to meet the various capital requirements can initiate regulatory action that could have a direct material effect on the financial statements. As of June 30, 2014, our bank's total risk-based capital ratio was 13.7%, with our bank's total regulatory capital equaling $319 million, or approximately $87 million in excess of the 10.0% minimum which is among the requirements to be categorized as "well capitalized." Our and our bank's capital ratios as of June 30, 2014 and December 31, 2013 are disclosed in Note 14 of the Notes to Condensed Consolidated Financial Statements. Results of Operations We recorded net income of $1.5 million for the second quarter of 2014 ($0.13 per basic and diluted share), compared to net income of $4.0 million ($0.46 per basic and diluted share) recorded during the second quarter of 2013. We recorded net income of $5.1 million ($0.50 per basic and diluted share) for the first six months of 2014, compared to net income of $8.4 million ($0.97 per basic and diluted share) recorded during the first six months of 2013. The results for the second quarter and the first six months of 2014 were impacted by the merger with Firstbank, which was consummated on June 1, 2014; operating results for the 2014 periods include one month of operations as a combined organization. After-tax merger-related costs totaled $2.4 million, or $0.21 per diluted share, during the second quarter of 2014 and $2.7 million, or $0.27 per diluted share, during the first six months of 2014; total merger-related expenses were negligible during the respective 2013 periods. We expect to record additional merger-related costs during the next several quarters, although we expect future costs to be considerably lower than the amounts expensed during the second quarter. --------------------------------------------------------------------------------



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-------------------------------------------------------------------------------- The decline in earnings performance in the second quarter and the first six months of 2014 compared to the respective prior-year periods primarily resulted from increased overhead costs. As noted above, significant merger-related costs were incurred in the 2014 periods, while a nominal level of such costs were recorded during the comparable 2013 periods. In addition, various nonmerger-related costs necessary to operate the combined company contributed to the increase in overhead costs. Higher net interest income, primarily resulting from the increase in average earning assets associated with the completion of the merger, partially mitigated the impact of the higher level of overhead costs on earnings performance. Interest income during the second quarter of 2014 was $18.5 million, an increase of $4.5 million, or 32.1%, from the $14.0 million earned during the second quarter of 2013. Interest income during the first six months of 2014 was $32.1 million, an increase of $3.9 million, or 13.1%, from the $28.2 million earned during the first six months of 2013. The increase in interest income in the 2014 periods compared to the respective 2013 periods is attributable to an increase in earning assets, which more than offset a declining yield on earning assets. Average earning assets include Firstbank's assets from the date of acquisition. The decreased yield on earning assets in the second quarter of 2014 was mainly attributable to a lower yield on average securities and a change in earning asset mix, while the decreased yield on earning assets during the first six months of 2014 was mainly due to decreased yields on average securities and average loans. Interest expense during the second quarter of 2014 was $2.9 million, an increase of $0.2 million, or 9.3%, from the $2.7 million expensed during the second quarter of 2013. Interest expense during the first six months of 2014 was $5.5 million, a slight increase from the $5.4 million expensed during the first six months of 2013. The increase in interest expense in the 2014 periods compared to the respective 2013 periods is attributable to an increase in the volume of average interest-bearing liabilities. Average interest-bearing liabilities include Firstbank's liabilities from the date of acquisition. The impact of the higher volume of average interest-bearing liabilities on interest expense was substantially offset by a decrease in the weighted average cost of interest-bearing liabilities. Maturing fixed-rate certificates of deposit were renewed at lower rates, replaced by lower-costing funds, or allowed to runoff during 2013 and the first six months of 2014. In addition, the lowering of interest rates on certain non-certificate of deposit accounts in the latter part of the fourth quarter of 2013 and the absorption of Firstbank's lower-costing interest-bearing liability base positively impacted the cost of funds in the 2014 periods. Net interest income during the second quarter of 2014 was $15.6 million, an increase of $4.3 million, or 37.5%, from the $11.3 million earned during the second quarter of 2013. Net interest income during the first six months of 2014 was $26.6 million, an increase of $3.8 million, or 16.9%, from the $22.8 million earned during the first six months of 2013. The increase in net interest income in the 2014 periods compared to the respective 2013 periods was due to an increase in earning assets, which more than offset a decline in the net interest margin. The net interest margin during the second quarter of 2014 was 3.62%, compared to 3.66% during the second quarter of 2013. During the first six months of 2014, the net interest margin was 3.53%, compared to 3.67% during the same time period in 2013. The declined net interest margin in the 2014 periods reflects the decreased yield on earning assets, which more than offset the reduction in the cost of funds. The following table sets forth certain information relating to our consolidated average interest-earning assets and interest-bearing liabilities and reflects the average yield on assets and average cost of liabilities for the second quarter of 2014 and 2013. Such yields and costs are derived by dividing income or expense by the average daily balance of assets or liabilities, respectively, for the period presented. Tax-exempt securities interest income and yield have been computed on a tax equivalent basis using a marginal tax rate of 35%. Securities interest income was increased by $100,000 and $114,000 in the second quarter of 2014 and 2013, respectively, for this adjustment. --------------------------------------------------------------------------------



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Quarters ended June 30, 2 0 1 4 2 0 1 3 Average Average Average Average Balance Interest Rate Balance Interest Rate (dollars in thousands) ASSETS Loans $ 1,377,986$ 16,657 4.85 % $ 1,044,527$ 12,687 4.87 % Investment securities 267,273 1,867 2.79 145,614 1,378 3.79 Federal funds sold 65,622 41 0.25 55,796 35 0.25 Interest-bearing deposits 24,119 17 0.28 7,724 6 0.29 Total interest - earning assets 1,735,000 18,582 4.30 1,253,661 14,106 4.51 Allowance for loan (26,100 ) losses (21,138 ) Other assets 168,756 136,809 Total assets $ 1,882,618$ 1,364,370 LIABILITIES AND SHAREHOLDERS' EQUITY Interest-bearing deposits $ 1,169,863$ 2,272 0.78 % $

887,408 $ 2,223 1.00 % Short-term borrowings 81,565 27 0.12 63,526 19 0.12 Federal Home Loan Bank advances 48,971 156 1.26 35,000 119 1.35 Other borrowings 46,410 474 4.04 34,482 319 3.68 Total interest-bearing liabilities 1,346,809 2,929 0.87 1,020,416 2,680 1.05 Noninterest-bearing 188,352 deposits 318,632 Other liabilities 11,620 5,124 Shareholders' equity 205,558 150,478 Total liabilities and $ 1,364,370 shareholders' equity $ 1,882,619 $ Net interest income $ 15,653$ 11,426 Net interest rate spread 3.43 % 3.46 % Net interest spread on 3.33 % 3.36 % average assets Net interest margin on 3.62 % 3.66 % earning assets A negative loan loss provision expense of $0.7 million was recorded during the second quarter of 2014, compared to a negative provision expense of $1.5 million during the second quarter of 2013. A negative loan loss provision expense of $2.6 million was recorded during the first six months of 2014, compared to a negative provision expense of $3.0 million during the first six months of 2013. The negative provision expense reflects recoveries of previously charged-off loans, reversals of specific reserves, a reduced level of loan-rating downgrades, and ongoing loan-rating upgrades as the quality of the loan portfolio continued to improve. Continued progress in the stabilization of economic and real estate market conditions and resulting collateral valuations also positively impacted provision expense. --------------------------------------------------------------------------------



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-------------------------------------------------------------------------------- Recoveries of previously charged-off loans totaled $0.7 million during the second quarter of 2014, while loan charge-offs not specifically reserved for in prior periods amounted to $0.1 million, resulting in a net positive impact of $0.6 million on provision expense. Recoveries of previously charged-off loans totaled $1.3 million during the first six months of 2014, while loan charge-offs not specifically reserved for in prior periods amounted to $0.2 million, resulting in a net positive impact of $1.1 million on provision expense. Net loan recoveries of $0.6 million were recorded during the second quarter of 2014, compared to net loan recoveries of $0.4 million during the prior-year second quarter. Net loan recoveries of $0.6 million were recorded during the first six months of 2014, compared to net loan charge-offs of $0.7 million during the same time period in 2013. Of the $0.7 million in gross loans charged-off during the first six months of 2014, $0.6 million, or about 80%, represents the elimination of specific reserves that were established through provision expense in earlier periods. Nonperforming loans totaled $5.7 million, or 0.5% of total originated loans, as of June 30, 2014, compared to $10.5 million, or 1.0% of total loans, as of June 30, 2013. The allowance equaled 1.8% of total originated loans as of June 30, 2014, compared to 2.4% of total loans as of June 30, 2013. Noninterest income during the second quarter of 2014 was $2.3 million, an increase of $0.5 million, or 29.1%, from the $1.8 million earned during the prior-year second quarter. Noninterest income during the first six months of 2014 was $3.8 million, an increase of $0.2 million, or 5.4%, from the $3.6 million earned during the same time period in 2013. The increase in noninterest income in the 2014 periods was mainly due to higher debit and credit card fee income and service charges on deposit accounts. Increased mortgage referral and sale fees also contributed to the higher level of noninterest income during the second quarter of 2014. These categories of noninterest income benefited from the consummation of the merger with Firstbank. Noninterest expense during the second quarter of 2014 was $16.1 million, an increase of $7.3 million, or 82.3%, from the $8.8 million expensed during the second quarter of 2013. Noninterest expense during the first six months of 2014 was $25.3 million, an increase of $7.9 million, or 45.3%, from the $17.4 million expensed during the same time period in 2013. The increase in noninterest expense in the second quarter of 2014 and the first six months of 2014 primarily resulted from higher merger-related costs and salary and benefit expenses. Merger-related costs totaled $3.5 million and $3.8 million during the second quarter of 2014 and the first six months of 2014, respectively; these costs were nominal during the respective 2013 periods. Salary and benefit expenses totaled $7.0 million during the second quarter of 2014, an increase of $2.0 million, or 41.3%, from the $5.0 million expensed during the prior-year second quarter. Salary and benefit expenses were $12.3 million during the first six months of 2014, an increase of $2.5 million, or 24.7%, from the $9.8 million expensed during the first six months of 2013. The increase in salary and benefit expenses was mainly due to the hiring of additional staff members over the past year and officer merit pay increases, along with the increase in employees associated with the completion of the merger with Firstbank. As of June 30, 2014, full-time equivalent employees numbered 645, up from 239 as of June 30, 2013. Increases in other categories of nonmerger-related costs necessary to operate the combined company also contributed to the higher level of overhead costs. --------------------------------------------------------------------------------



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During the second quarter of 2014, we recorded income before federal income tax of $2.5 million and a federal income tax expense of $1.0 million. During the second quarter of 2013, we recorded income before federal income tax of $5.8 million and a federal income tax expense of $1.8 million. The decrease in federal income tax expense in the second quarter of 2014 resulted from the lower level of income before federal income tax, which more than offset an increase in our effective tax rate from 30.4% in the second quarter of 2013 to 39.0% in the second quarter of 2014. During the first six months of 2014, we recorded income before federal income tax of $7.7 million and a federal income tax expense of $2.6 million. During the first six months of 2013, we recorded income before federal income tax of $12.0 million and a federal income tax expense of $3.6 million. The decrease in federal income tax expense during the first six months of 2014 resulted from the lower level of income before federal income tax, which more than offset an increase in our effective tax rate from 29.7% in the 2013 period to 34.2% in the 2014 period. The increase in the effective tax rate in the 2014 periods is primarily due to the recording of nondeductible merger-related expenses.


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