Merchants Bancorp: Form 10-Q for the period ended Jun 30, 2023

Management’s discussion and analysis of the financial condition at June 30, 2023 and results of operations for the three and six months ended June 30, 2023 and 2022, is intended to assist in understanding the financial condition and results of operations of the Company. The information contained in this section should be read in conjunction with the unaudited condensed consolidated financial statements and the notes thereto, appearing in Part I, Item 1 of this Form 10-Q.

The words “the Company,” “we,” “our” and “us” refer to Merchants Bancorp and its consolidated subsidiaries, unless we indicate otherwise.

Financial Highlights for the Three Months Ended June 30, 2023

• Net income of $65.3 million increased 21% compared to June 30, 2022 and diluted earnings per share of $1.31 increased 18% compared to June 30, 2022.
• The 21% increase in net income was primarily driven by a $33.6 million, or 47%, increase in net interest income, a $14.8 million, or 82%, decrease in the provision for income tax, a $16.4 million, or 264%, increase in provision for credit losses, a $11.4 million, or 34%, increase in noninterest expense, and a $10.2 million, or 47%, decrease in gain on sale of loans.
• During the three months ended June 30, 2023, the Company recorded a $13.0 million tax benefit related to tax refunds receivable and changes to its state tax apportionment calculations, which was offset by credit events that totaled approximately $14.8 million, primarily for the impact of a multi-family loan charge-off, an increase in specific reserves for a healthcare customer, and changes to qualitative factors and forecasted loss rates.
• Total assets of $15.9 billion increased 11% compared to March 31, 2023, and increased 26% compared to December 31, 2022.
• As of June 30, 2023, the Company had $5.3 billion, or 34%, of total assets, in unused borrowing capacity with the Federal Home Loan Bank and the Federal Reserve Discount window, based on available collateral.
• The Company’s most liquid assets are in unrestricted cash, short-term investments, including interest-bearing demand deposits, mortgage loans in process of securitization, loans held for sale, and warehouse lines of credit included in loans receivable. Taken together, with unused borrowing capacity, these totaled $10.2 billion, or 64%, of the $15.9 billion in total assets as of June 30, 2023.
• Uninsured deposits totaled approximately $2 billion as of June 30, 2023, representing less than 20% of total deposits.
• Loans receivable of $9.9 billion, net of allowance for credit losses on loans, increased $1.3 billion, or 15%, compared to March 31, 2023, and increased $2.4 billion, or 33%, compared to December 31, 2022.
• Efficiency ratio was 32.7% compared to 29.6% for the three months ended June 30, 2022.
• As of June 30, 2023, approximately 94% of the total net loans at Merchants Bank reprice within three months, which reduces the risk of market rate increases.
• Tangible book value per common share of $24.14 increased 23% compared to $19.70 for the three months ended June 30, 2022.
• The volume of warehouse loans funded during the three months ended June 30, 2023 amounted to $8.4 billion, a decrease of $459.1 million, or 5%, compared to the three months ended June 30, 2022. This compared to the 32% industry decrease in single-family residential loan volumes for the three months ended June 30, 2023 to the same period in 2022, according to an estimate of industry volume by the Mortgage Bankers Association.
• The volume of loans originated and acquired for sale in the secondary market through our multi-family business increased by $261.8 million, or 64%, to $668.2 million, compared to $406.4 million for the three months ended June 30, 2022.

Business Overview

We are a diversified bank holding company headquartered in Carmel, Indiana and registered under the Bank Holding Company Act of 1956, as amended. We currently operate in multiple business segments, including Multi-family Mortgage Banking that offers multi-family housing and healthcare facility financing and servicing, as well as syndicated low-income housing tax credit and debt funds; Mortgage Warehousing that offers mortgage warehouse financing, commercial loans, and deposit services; and Banking that offers portfolio lending for multi-family and healthcare facility loans, retail and correspondent residential mortgage banking, agricultural lending, Small Business Administration (“SBA”) lending, and traditional community banking.

Our business consists primarily of funding fixed rate, low risk, multi-family, residential and SBA loans meeting underwriting standards of government programs under an originate to sell model, and retaining adjustable rate loans as held for investment to reduce interest rate risk. The gain on sale of these loans and servicing fees contribute to noninterest income. The funding source is primarily from mortgage custodial, municipal, retail, commercial, brokered deposits, and short-term borrowing. We believe that the combination of net interest income and noninterest income from the sale of low risk profile assets results in lower than industry charge-offs and a lower expense base which serves to maximize net income and higher than industry shareholder return.

Critical Accounting Policies and Estimates

The preparation of our consolidated financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, and expenses. These estimates are based upon historical experience and on various other assumptions that management believes are reasonable under the current circumstances. These estimates form the basis for making judgments about the carrying value of certain assets and liabilities that are not readily available from other sources. Actual results may differ from these estimates under different assumptions or conditions.

The estimates and judgments that management believes have the most effect on its reported financial position and results of operations are set forth within “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2022. There have been no significant changes in critical accounting policies or the assumptions and judgments utilized in applying these policies since those reported for the year ended December 31, 2022.

Financial Condition

As of June 30, 2023, we had approximately $15.9 billion in total assets, $13.1 billion in deposits and $1.6 billion in total shareholders’ equity. Total assets as of June 30, 2023 included approximately $377.3 million of cash and cash equivalents, $3.1 billion of loans held for sale and $9.9 billion of loans receivable, net of ACL-loans. Assets also included $298.9 million of mortgage loans in process of securitization that represent pre-sold multi-family rental real estate loan originations in primarily Government National Mortgage Association (“GNMA”) mortgage backed securities pending settlements that typically occur within 30 days. There was also $1.1 billion in securities held to maturity that were primarily acquired in conjunction with the securitization of loans that the Company originated. Additionally, we had $648.0 million in securities available for sale that are typically match funded with related custodial deposits or required to collateralize our credit-linked notes. There are some restrictions on the types of securities we hold, particularly for those that are funded by certain custodial deposits where we set the cost of deposits based on the yield of the related securities. Servicing rights at June 30, 2023 were $147.3 million based on the fair value of the loan servicing, which are primarily GNMA multi-family servicing rights with 10-year call protection.

Comparison of Financial Condition at June 30, 2023 and December 31, 2022

Total Assets. Total assets increased $3.3 billion, or 26%, to $15.9 billion at June 30, 2023 from $12.6 billion at December 31, 2022. The increase was due primarily to significant growth in the mortgage warehouse, multi-family, and healthcare loan portfolios.

Cash and Cash Equivalents. Cash and cash equivalents increased $151.1 million, or 67%, to $377.3 million at June 30, 2023 from $226.2 million at December 31, 2022. The 67% increase reflected higher liquidity to fund anticipated loan growth. Included in cash equivalents was $35.3 million in restricted cash associated with the March 2023 issuance of senior credit linked notes described in Note 11: Borrowings.

Mortgage Loans in Process of Securitization. Mortgage loans in process of securitization increased $144.7 million, or 94%, to $298.9 million at June 30, 2023, from $154.2 million at December 31, 2022. These represent loans that our banking subsidiary, Merchants Bank, has funded and are held pending settlement, primarily as GNMA or other agency mortgage-backed securities with a firm investor commitment to purchase the securities. The 94% increase was primarily due to an increase in the volume of loans that had not yet settled with government agencies.

Securities Available for Sale. Securities available for sale increased $324.7 million, or 100%, to $648.0 million at June 30, 2023, from $323.3 million at December 31, 2022. The increase in available for sale securities was primarily due to purchases of $513.5 million and a decrease of unrealized loss on securities of $4.8 million, partially offset by calls, maturities, repayments and sales of securities totaling $195.2 million during the period.

As of June 30, 2023, Accumulated Other Comprehensive Losses (“AOCL”) of $7.0 million losses, related to securities available for sale, decreased $3.5 million, or 33%, compared to losses of $10.5 million at December 31, 2022. The $7.0 million of AOCL losses as of June 30, 2023 represented less than 1% of total equity and 1% of total securities available for sale.

Securities Held to Maturity. Securities held to maturity decreased $57.1 million, or 5%, to $1.1 billion at June 30, 2023 from December 31, 2022. The decrease was primarily due to purchases of $4.3 million offset by calls, maturities and repayments of securities totaling $61.3 million during the period.

Loans Held for Sale. Loans held for sale, comprised primarily of single-family residential real estate loan participations that meet Federal National Mortgage Association (“Fannie Mae”), Federal Home Loan Mortgage Corporation (“Freddie Mac”), or Ginnie Mae (“GNMA”) eligibility, increased $147.4 million, or 5%, to $3.1 billion at June 30, 2023 from $2.9 billion at December 31, 2022. The increase in loans held for sale was due primarily to a increase in warehouse participations, as the industry experienced higher volume.

Loans Receivable. Loans receivable, which are comprised of loans held for investment, increased $2.4 billion, or 33%, to $9.9 billion at June 30, 2023 compared to December 31, 2022. The increase was comprised primarily of:

• an increase of $737.1 million, or 159%, in mortgage warehouse lines of credit, to $1.2 billion at June 30, 2023,
• an increase of $610.8 million, or 19%, in multi-family financing loans, to $3.7 billion at June 30, 2023,
• an increase of $524.0 million, or 33%, in healthcare financing loans, to $2.1 billion at June 30, 2023,
• an increase of $415.6 million, or 42%, in commercial and commercial real estate loans, to $1.4 billion at June 30, 2023, and
• an increase of $164.2 million, or 14%, in residential real estate loans, to $1.3 billion at June 30, 2023.

The $737.1 million increase in mortgage warehouse lines of credit was due to higher loan volume.

The $610.8 million increase in multi-family financing was due to higher origination volume for construction, bridge and other loans generated through our multi-family segment that will remain on our balance sheet until they convert to permanent financing or are otherwise paid off over an average of one to three years.

The $524.0 million increase in healthcare financing was due to transfers of loans previously in loans held for sale, associated with our credit link note transaction.

The $415.6 million increase in commercial and commercial real estate was due to higher revolving lines of credit on collateralized mortgage servicing rights during the period.

The $164.2 million increase in residential real estate loans was primarily due an increase in All-in-One®, first-lien HELOCs.

As of June 30, 2023, approximately 94% of the total net loans at Merchants Bank reprice within three months, which reduces the risk of market rate increases.

Allowance for Credit Losses on Loans (“ACL-Loans”). The ACL-Loans of $63.0 million at June 30, 2023 increased $19.0 million compared to $44.0 million at December 31, 2022. The increase was primarily due to:

• loan growth in the period,
• replenishment of $8.2 million related to the charge-off of a loan in the multi-family portfolio,
• a $4.6 million increase related to changes in qualitative factors and forecasted loss rates to reflect changes in industry conditions, such as the impact of higher rates, and
• a $2.0 million increase in net specific reserves, primarily related to a loan in the healthcare portfolio.

The increases were partially offset by charge-offs of $9.5 million, primarily associated with a multi-family customer.

Also influencing the overall level of the ACL-Loans is our differentiated strategy to typically hold loans with shorter durations and to maintain strict underwriting standards that enable us to sell the majority of our loans to government agencies.

Goodwill. Goodwill of $15.8 million at June 30, 2023 remained unchanged compared to December 31, 2022. At this time, we do not believe there exists any impairment to goodwill or intangible assets.

Servicing Rights. Servicing rights increased $1.0 million, or 1%, to $147.3 million at June 30, 2023 compared to $146.3 million at December 31, 2022. During the six months ended June 30, 2023, originated servicing of $4.3 million and a positive fair market value adjustment of $0.5 million were partially offset by paydowns of $3.8 million. Servicing rights are recognized in connection with sales of loans when we retain servicing of the sold loans, as well as upon purchases of loan servicing portfolios. The servicing rights are recorded and carried at fair value. The fair value increase recorded during the six months ended June 30, 2023 was driven by higher loan balances of mortgages serviced and higher interest rates that impacted fair market value adjustments. The value of servicing rights generally increases in rising interest rate environments and declines in falling interest rate environments due to expected prepayments.

Other Assets and Receivables. Other assets and receivables increased $105.1 million, or 67%, to $262.5 million at June 30, 2023 compared to $157.4 million at December 31, 2022. The 67% increase in other assets and receivables was primarily due to the acquisition of low-income housing tax credit investments.

Deposits. Deposits increased $3.0 billion, or 30%, to $13.1 billion at June 30, 2023 from $10.1 billion at December 31, 2022. The 30% increase in total deposits was primarily due to a $2.2 billion increase in certificates of deposit and a $885.2 million increase in demand deposits, partially offset by a decrease of $88.7 million in savings deposits. As of June 30, 2023, approximately 83% of the total deposits at Merchants Bank reprice within three months.

Uninsured deposits totaled approximately $2 billion as of June 30, 2023, representing less than 20% of total deposits. Since 2018, the Company has offered its customers an opportunity to insure balances in excess of $250,000 through our insured cash sweep program that extends FDIC protection up to $100 million. The balance of deposits in this program was $1.7 billion as of June 30, 2023.

We increased our use of brokered deposits by $2.0 billion, or 72%, to $4.8 billion at June 30, 2023 compared to December 31, 2022. Brokered deposits represented 36% of total deposits at June 30, 2023, compared to 27% of total deposits at December 31, 2022.

• Brokered certificates of deposit accounts increased by $1.9 billion, or 72%, to $4.6 billion at June 30, 2023 compared to December 31, 2022.
• Brokered demand deposit accounts increased by $125.1 million, to $125.1 million at June 30, 2023 compared to December 31, 2022.
• Brokered savings deposits accounts decreased $75.3 million, or 92%, to $6.2 million at June 30, 2023 compared to December 31, 2022.

Although our brokered deposits are short-term in nature, they may be more rate sensitive compared to other sources of funding. In the future, those depositors may not replace their brokered deposits with us as they mature, or we may have to pay a higher rate of interest to keep those deposits or to replace them with other deposits or other sources of funds. Not being able to maintain or replace those deposits as they mature would adversely affect our liquidity. Additionally, if Merchants Bank does not maintain its well-capitalized position, it may not accept or renew any brokered deposits without a waiver granted by the Federal Deposit Insurance Corporation (“FDIC”).

Compared to December 31, 2022, interest-bearing deposits increased $3.0 billion, or 30%, to $12.7 billion at June 30, 2023, and noninterest-bearing deposits increased $22.5 million, or 7%, to $349.4 million at June 30, 2023.

Borrowings. Borrowings totaled $1.0 billion at June 30, 2023, an increase of $86.4 million, or 9%, from December 31, 2022. The increase was primarily due to the issuance of senior credit linked notes described in Note 11: Borrowings. Depending on rates and timing, borrowing can be a more effective liquidity management alternative than utilizing brokered certificates of deposits. The Company primarily utilizes borrowing facilities from the FHLB, the Federal Reserve’s discount window, and the American Financial Exchange (“AFX”).

The Company continues to have significant borrowing capacity based on available collateral. As of June 30, 2023, unused lines of credit totaled $5.3 billion, compared to $3.1 billion at December 31, 2022.

Other Liabilities. Other liabilities increased $87.7 million, or 65%, to $221.8 million at June 30, 2023 compared to $134.1 million at December 31, 2022. The 65% increase in other liabilities was primarily due to unfunded commitments for low-income housing tax credit investments.

Total Shareholders’ Equity. Total shareholders’ equity was $1.6 billion as of June 30, 2023, compared to $1.5 billion as of December 31, 2022. The $100.6 million increase resulted primarily from net income of $120.3 million, which was partially offset by dividends paid on common and preferred shares of $24.3 million during the period.

Asset Quality

Total nonperforming loans (nonaccrual and greater than 90 days late but still accruing) were $68.4 million, or 0.69%, of total loans at June 30, 2023, compared to $26.7 million, or 0.36%, of total loans at December 31, 2022 and $4.8 million, or 0.07%, at June 30, 2022. The increase in non-performing loans compared to both periods was primarily due to 3 customers, while the remainder of our loan portfolio continued to generally perform as expected.

As a percentage of nonperforming loans, the ACL-Loans was 92% at June 30, 2023 compared to 165% at December 31, 2022 and 778.6% at June 30, 2022. The decrease compared to both periods were primarily due to the increases in the nonperforming loans.

Total loans greater than 30 days past due were $92.9 million at June 30, 2023, $39.8 million at December 31, 2022, and $4.9 million at June 30, 2022. The increase in non-performing loans compared to both periods was primarily due to 3 customers.

Special Mention (Watch) loans were $188.5 million at June 30, 2023, compared to $137.8 million at December 31, 2022 and $131.2 million at June 30, 2022.

During the three months ended June 30, 2023 there were $9.5 million of charge-offs and $2,000 of recoveries, compared to $47,000 of charge-offs and $651,000 recoveries for the three months ended June 30, 2022.

For the six months ended June 30, 2023, there were $9.5 million of charge-offs and $16,000 of recoveries, compared to $978,000 of charge-offs and $658,000 of recoveries for the six months ended June 30, 2022.

Comparison of Operating Results for the Three Months Ended June 30, 2023 and 2022

General. Net income of $65.3 million for the three months ended June 30, 2023 increased by $11.4 million, or 21%, compared to the three months ended June 30, 2022. The increase was primarily driven by a $33.6 million, or 47%, increase in net interest income, a $14.8 million, or 82%, decrease in the provision for income tax, a $16.4 million, or 264%, increase in provision for credit losses, a $11.4 million, or 34%, increase in noninterest expense, and a $10.2 million, or 47%, decrease in gain on sale of loans. Included in the results were the following:

• a $13.0 million tax benefit related to tax refunds receivable and changes to its state tax apportionment calculations described in the Provision for Income Tax section below, and
• credit events that totaled approximately $14.8 million for the impact of a multi-family loan charge-off, an increase in specific reserves for a healthcare customer, and changes to qualitative factors and forecasted loss rates, described in the Provision for Credit Losses section below.

Net Interest Income. Net interest income increased $33.6 million, or 47%, to $105.6 million for the three months ended June 30, 2023, compared with $72.0 million for the three months ended June 30, 2022. The 47% increase reflected a $168.8 million, or 189%, increase in interest income from higher yields and average loan balances, partially offset by a $135.2 million increase in interest expense from higher interest rates on deposits and higher average rates on borrowings, primarily related to the credit linked notes issued by the Company during the three months ended March 31, 2023. The interest rate spread of 2.41% for the three months ended June 30, 2023 decreased 49 basis points compared to 2.90% in the three months ended June 30, 2022.

Our net interest margin decreased 6 basis points, to 2.97%, for the three months ended June 30, 2023 from 3.03% for the three months ended June 30, 2022.

Interest Income. Interest income increased $168.8 million, or 189%, to $258.1 million for the three months ended June 30, 2023, compared with $89.3 million for the three months ended June 30, 2022. This increase was primarily attributable to an increase in both higher average yields and balances of loans and loans held for sale, as well as higher balances in securities held to maturity.

The average balance of loans, including loans held for sale, during the three months ended June 30, 2023 increased $3.3 billion, or 38%, to $12.0 billion compared to the three months ended June 30, 2022. The average yield on loans increased 368 basis points, to 7.67% for the three months ended June 30, 2023, compared to 3.99% for the three months ended June 30, 2022. The increase in average balances of loans and loans held for sale was primarily due to increases in the multi-family and healthcare portfolios, but all loan portfolios contributed to the growth during the period.

The average balance of securities held to maturity, during the three months ended June 30, 2023 increased $1.1 billion, or 100%, to $1.1 billion compared to the three months ended June 30, 2022, as none were owned as of June 30, 2022. The average yield on securities held to maturity was 6.35% for the three months ended June 30, 2023.

The average balance of securities available for sale increased $342.1 million, or 103%, to $672.9 million for the three months ended June 30, 2023 from $330.8 million for the three months ended June 30, 2022, while the average yield increased 221 basis points, to 3.32% for the three months ended June 30, 2023, compared to 1.11% for the three months ended June 30, 2022.

The average balance of interest-earning deposits and other decreased $117.8 million, or 32%, to $249.7 million for the three months ended June 30, 2023 from $367.5 million for the three months ended June 30, 2022, while the average yield increased 437 basis points, to 5.36% for the three months ended June 30, 2023, compared to 0.99% for the three months ended June 30, 2022.

The average balance of mortgage loans in process of securitization increased $81.7 million, or 41%, to $280.1 million for the three months ended June 30, 2023 compared to the three months ended June 30, 2022, while the average yield increased 155 basis points, to 4.48% for the three months ended June 30, 2023, compared to 2.93% for the three months ended June 30, 2022.

Interest Expense. Total interest expense increased $135.2 million, or 784%, to $152.5 million for the three months ended June 30, 2023, compared to the three months ended June 30, 2022.

Interest expense on deposits increased $123.0 million, or 833%, to $137.8 million for the three months ended June 30, 2023 from $14.8 million for the three months ended June 30, 2022. The increase was primarily due to higher rates on certificates of deposit, interest-bearing checking, and money market accounts.

The average balance of certificates of deposit of $4.7 billion for the three months ended June 30, 2023 increased $4.1 billion, or 639%, compared to the three months ended June 30, 2022. The average yield of certificates of deposit was 4.98% for the three months ended June 30, 2023, which was a 423 basis point increase compared to 0.75% for three months ended June 30, 2022.

The average balance of interest-bearing checking accounts of $4.3 billion for the three months ended June 30, 2023 increased $457.9 million, or 12%, compared to $3.8 billion for the three months ended June 30, 2022. The average yield of interest-bearing checking accounts was 4.50% for the three months ended June 30, 2023, which was a 378 basis point increase compared to 0.72% for three months ended June 30, 2022.

The average balance of money market accounts of $2.7 billion for the three months ended June 30, 2023 increased $122.6, or 5%, compared to $2.6 billion for the three months ended June 30, 2022. The average yield of money market accounts was 4.45% for the three months ended June 30, 2023, which was a 345 basis point increase compared to 1.00% for three months ended June 30, 2022.

Interest expense on borrowings increased $12.2 million, or 493%, to $14.7 million for the three months ended June 30, 2023 from $2.5 million for the three months ended June 30, 2022. The increase reflected an 862 basis points increase in the average cost of borrowings, to 9.94% compared to 1.32% for the three months ended June 30, 2022. The increase was primarily related to the credit linked notes issued by the Company during the three months ended June 30, 2023. Partially offsetting the higher rates on borrowing was a $158.3 million, or 21%, decrease in the average balance of borrowings of $591.3 million compared to $749.6 million for the three months ended June 30, 2022. Also included in borrowings, our warehouse structured financing agreements provide for additional interest payments for a portion of the earnings generated. As a result, the cost of borrowings increased from a base rate of 9.53% and 0.80%, to an effective rate of 9.94% and 1.32% for the three months ended June 30, 2023 and 2022, respectively.

The following table presents, for the periods indicated, information about (i) average balances, the total dollar amount of interest income from interest-earning assets and the resultant average yields; (ii) average balances, the total dollar amount of interest expense on interest-bearing liabilities and the resultant average rates; (iii) net interest income; (iv) the interest rate spread; and (v) the net interest margin. Yields have been calculated on a pre-tax basis. Nonaccrual loans are included in loans and loans held for sale.

(Dollars in thousands)

Increases and decreases in interest income and interest expense result from changes in average balances (volume) of interest-earning assets and interest-bearing liabilities, as well as changes in weighted average interest rates. The following table sets forth the effects of changing rates and volumes on our net interest income during the periods shown. Information is provided with respect to (i) effects on interest income attributable to changes in volume (changes in volume multiplied by prior rate) and (ii) effects on interest income attributable to changes in rate (changes in rate multiplied by prior volume). Changes applicable to both volume and rate have been allocated to volume. Yields have been calculated on a pre-tax basis.

The following table summarizes the increases and decreases in interest income and interest expense resulting from changes in average balances (volume) and changes in average interest rates:

(Dollars in thousands)

Provision for Credit Losses. We recorded a total provision for credit losses of $22.6 million for the three months ended June 30, 2023, an increase of $16.4 million, compared to the three months ended June 30, 2022. The increase was primarily due to:

• loan growth in the period,
• replenishment of $8.2 million related to the charge-off of a loan in the multi-family portfolio,
• a $4.6 million increase related to changes in qualitative factors and forecasted loss rates to reflect changes in industry conditions, such as the impact of higher rates, and
• a $2.0 million increase in net specific reserves, primarily related to a loan in the healthcare portfolio.

The $22.6 million total provision for credit losses consisted of $20.7 million for the ACL-Loans and $1.9 million for the ACL-OBCE’s. The ACL-Loans was $63.0 million, or 0.64%, of total loans, at June 30, 2023, compared to $44.0 million, or 0.59%, of total loans, at December 31, 2022, and $37.5 million, or 0.53%, at June 30, 2023.

Noninterest Income. Noninterest income decreased $9.3 million, or 24%, to $29.9 million for the three months ended June 30, 2023 compared to $39.2 million for the three months ended June 30, 2022. The decrease was primarily due to a $10.2 million, or 47%, decrease in gain on sale of loans associated with a business mix shift in multi-family lending, from volumes sold in the secondary market towards those maintained on the balance sheet.

A summary of the gain on sale of loans for the three months ended June 30, 2023 and 2022 is below:

(in thousands)

A $1.0 million, or 10%, decrease in loan servicing fees also contributed to the lower noninterest income. Loan servicing fees included a $3.4 million positive fair market value adjustment to servicing rights for the three months ended June 30, 2023, compared to a $7.7 million positive adjustment to fair value of servicing rights for the three months ended June 30, 2022.

Noninterest Expense. Noninterest expense increased $11.4 million, or 34%, to $44.3 million for the three months ended June 30, 2023 compared to the three months ended June 30, 2022. The increase was due primarily to a $3.2 million, or 14%, increase in salaries and employee benefits to support loan growth, as well as a $3.1 million, or 468%, increase in FDIC deposit insurance expenses, reflecting our growth in assets, Higher professional fees also contributed $2.1 million to the increase. The efficiency ratio was at 32.71% for the three months ended June 30, 2023, compared with 29.64% for the three months ended June 30, 2022.

Income Taxes. Provision for income tax decreased $14.8 million, or 82%, to $3.3 million for the three months ended June 30, 2023, compared to $18.1 million for the three months ended June 30, 2022. The decrease reflected a $13.0 million tax benefit related to tax refunds receivable and changes to state tax apportionment calculations.

During the three months ended June 30, 2023, the Company received an advisory letter it had requested from the State of Indiana related to certain state tax apportionment provisions in the Indiana Financial Institution Tax Code and Regulations. The advisory letter provided guidance related to the methodology used to determine and source the receipts in the state of Indiana for the Company’s mortgage origination and warehousing service lines. In effect, the guidance provided the Company the ability to revise its state income tax apportionment calculation to reduce its Indiana tax and related deferred tax liabilities. As such, the Company will amend several of its state returns and request the respective refunds. In anticipation of the refunds, a receivable was established as of June 30, 2023. On July 21, 2023, the company received a final revenue ruling from the Indiana Department of Revenue supporting the revised methodology. Additionally, the change in methodology is expected to result in a 1.0% to 1.5% reduction in the Company’s overall effective tax rate in the future.

The effective tax rate was 4.8% for the three months ended June 30, 2023 and 25.1% for the three months ended June 30, 2022.

Comparison of Operating Results for the Six Months Ended June 30, 2023 and 2022

General. Net income for the six months ended June 30, 2023 was $120.3 million, an increase of $16.2 million, or 16%, from net income of $104.1 million for the six months ended June 30, 2022. The increase was primarily due to a $68.6 million increase in net interest income and a $13.2 million decrease in provision for income taxes that was partially offset by a $29.6 million decrease in noninterest income, a $20.8 million increase in the provision for credit losses, and an $15.1 million increase in noninterest expense. Included in the results were the following:

• a $13.0 million tax benefit related to tax refunds receivable and changes to its state tax apportionment calculations described in the Provision for Income Tax section below, and
• credit events that occurred during the three months ended June 30, 2023 totaling approximately $14.8 million for the impact of a multi-family loan charge-off, an increase in specific reserves for a healthcare customer, and changes to qualitative factors and forecasted loss rates, described in the Provision for Credit Losses section below.

Net Interest Income. Net interest income increased $68.6 million, or 50%, to $206.3 million for the six months ended June 30, 2023, compared to the six months ended June 30, 2022. The 50% increase reflected a $304.1 million, or 184%, increase in interest income from higher yields and average loan balances, partially offset by a $235.5 million, or 856%, increase in interest expense from higher interest rates and average balances of deposits. The interest rate spread of 2.57% for the six months ended June 30, 2023 decreased 15 basis points compared to 2.72% in the six months ended June 30, 2022.

Our net interest margin increased 29 basis points, to 3.11%, for the six months ended June 30, 2023 from 2.82% for the six months ended June 30, 2022.

Interest Income. Interest income increased $304.1 million, or 184%, to $469.4 million for the six months ended June 30, 2023, compared with $165.3 million for the six months ended June 30, 2022. This increase was primarily attributable to an increase in higher average yields and loan balances, as well as higher balances of held to maturity securities that were acquired after June 30, 2022.

The average balance of loans, including loans held for sale, during the six months ended June 30, 2023 increased $2.9 billion, or 35%, to $11.3 billion compared to the six months ended June 30, 2022, and the average yield on loans increased 365 basis points, to 7.47% for the six months ended June 30, 2023, compared to 3.82% for the six months ended June 30, 2022.

The average balance of securities held to maturity, during the six months ended June 30, 2023 increased $1.1 billion, or 100%, to $1.1 billion compared to the six months ended June 30, 2022, as none were owned as of June 30, 2022. The average yield on securities held to maturity was 6.04% for the three months ended June 30, 2023.

The average balance of securities available for sale increased $241.6 million, or 76%, to $559.9 million for the six months ended June 30, 2023, from the six months ended June 30, 2022, and the average yield increased 179 basis points, to 2.82% for the six months ended June 30, 2023, compared to 1.03% for the six months ended June 30, 2022.

The average balance of interest-earning deposits and other decreased $693.7 million, or 76%, to $217.3 million for the six months ended June 30, 2023, from $911.0 million for the six months ended June 30, 2022, and the average yield increased 472 basis points, to 5.11% for the six months ended June 30, 2023, compared to 0.39% for the six months ended June 30, 2022.

Interest Expense. Total interest expense increased $235.5 million, or 856%, to $263.1 million for the six months ended June 30, 2023, compared to the six months ended June 30, 2022.

Interest expense on deposits increased $218.7 million, or 927%, to $242.2 million for the six months ended June 30, 2023, compared to the six months ended June 30, 2022. The increase was primarily due to increases in interest rates on certificates of deposit, interest-bearing checking and money market accounts.

The average balance of certificates of deposit accounts was $4.0 billion for the six months ended June 30, 2023, an increase of $3.2 billion, or 369%, compared to the six months ended June 30, 2022. The average yield on certificates of deposit accounts was 4.68% for the six months ended June 30, 2023, which was a 409 basis point increase compared to 0.59% for six months ended June 30, 2022.

The average balance of interest-bearing checking accounts of $4.2 billion for the six months ended June 30, 2023 increased $248.3 million, or 6%, compared to $3.9 billion for the six months ended June 30, 2022. The average yield of interest-bearing checking accounts was 4.29% for the six months ended June 30, 2023, which was a 382 basis point increase compared to 0.47% for six months ended June 30, 2022.

The average balance of money market accounts of $2.8 billion for the six months ended June 30, 2023 increased $130.0 million, or 5%, compared to $2.7 million for the six months ended June 30, 2022. The average yield of money market accounts was 4.26% for the six months ended June 30, 2023, which was a 337 basis point increase compared to 0.89% for six months ended June 30, 2022.

Interest expense on borrowings increased $16.9 million, or 428%, to $20.8 million for the six months ended June 30, 2023 from the six months ended June 30, 2022. The increase was due primarily to a 662 basis points increase in the average cost of borrowings to 7.81% compared to 1.19% for the six months ended June 30, 2022. The increase was primarily related to the credit linked notes issued by the Company during the three months ended June 30, 2023. The higher average rates were partially offset by a $132.7 million decrease in average balances compared to the six months ended June 30, 2022. Additionally, borrowings include our warehouse structured financing agreements that provide for additional interest payments for a portion of the earnings generated. As a result, the cost of borrowings increased from a base rate of 7.43% and 0.61%, to an effective rate of 7.81% and 1.19% for the six months ended June 30, 2023 and 2022, respectively.

The following table presents, for the periods indicated, information about (i) average balances, the total dollar amount of interest income from interest-earning assets and the resultant average yields; (ii) average balances, the total dollar amount of interest expense on interest-bearing liabilities and the resultant average rates; (iii) net interest income; (iv) the interest rate spread; and (v) the net interest margin. Yields have been calculated on a pre-tax basis. Nonaccrual loans are included in loans and loans held for sale.

(Dollars in thousands)

Increases and decreases in interest income and interest expense result from changes in average balances (volume) of interest-earning assets and interest-bearing liabilities, as well as changes in weighted average interest rates. The following table sets forth the effects of changing rates and volumes on our net interest income during the periods shown. Information is provided with respect to (i) effects on interest income attributable to changes in volume (changes in volume multiplied by prior rate) and (ii) effects on interest income attributable to changes in rate (changes in rate multiplied by prior volume). Changes applicable to both volume and rate have been allocated to volume. Yields have been calculated on a pre-tax basis.

The following table summarizes the increases and decreases in interest income and interest expense resulting from changes in average balances (volume) and changes in average interest rates:

(Dollars in thousands)

Provision for Loan Losses. We recorded a provision for credit losses of $29.5 million for the six months ended June 30, 2023, an increase of $20.8 million, or 240%, compared to $8.7 million for the six months ended June 30, 2022. The increase was primarily due to:

• loan growth in the period,
• replenishment of $8.2 million related to the charge-off of a loan in the multi-family portfolio,
• a $4.6 million increase related to changes in qualitative factors and forecasted loss rates to reflect changes in industry conditions, such as the impact of higher rates, and
• a $2.0 million increase in net specific reserves, primarily related to a loan in the healthcare portfolio.

The $29.5 million total provision for credit losses consisted of $28.5 million for the ACL-Loans and $1.0 million for the ACL-OBCE’s. The ACL-Loans was $63.0 million, or 0.64%, of total loans, at June 30, 2023, compared to $44.0 million, or 0.59%, of total loans, at December 31, 2022, and $37.5 million, or 0.53%, at June 30, 2022.

Noninterest Income. Noninterest income decreased $29.6 million, or 40%, to $44.1 million for the six months ended June 30, 2023 compared to the six months ended June 30, 2022. The decrease was primarily due to a $21.4 million, or 54%, decrease in gain on sale of loans associated with a shift in business mix to programs with lower average trade pricing in the multi-family loan portfolio, as well as lower single-family and multi-family secondary market volumes.

A summary of the gain on sale of loans for the six months ended June 30, 2023 and 2022 is below:

(in thousands)

Also contributing to the lower noninterest income was an $8.4 million decrease in loan servicing fees compared to the six months ended June 30, 2022. Included in loan servicing fees was a $0.5 million positive adjustment to the fair value of servicing rights for the six months ended June 30, 2023, compared to a positive adjustment of $15.4 million for the six months ended June 30, 2022.

Partially offsetting the decreases in noninterest income was a $2.9 million increase in syndication and asset management fees compared to the six months ended June 30, 2022. This line of business is becoming a meaningful source of noninterest income.

Noninterest Expense. Noninterest expense increased $15.1 million, or 24%, to $79.1 million for the six months ended June 30, 2023 compared to the six months ended June 30, 2022. The increase was primarily due to a $4.6 million, or 319%, increase in deposit insurance expense, reflecting asset growth. Also contributing to the higher noninterest expenses was a $4.1 million increase in salaries and employee benefits to support loan growth, as well as a $3.1 million increase in professional fees. The efficiency ratio was at 31.58% in the six months ended June 30, 2023, compared with 30.25% in the six months ended June 30, 2022.

Income Taxes. Provision for income taxes decreased $13.2 million, or 38%, to $21.6 million for the six months ended June 30, 2023 from $34.8 million for the six months ended June 30, 2022. The decrease reflected a $13.0 million tax benefit related to tax refunds receivable and changes to state tax apportionment calculations.

During the three months ended June 30, 2023, the Company received an advisory letter that it requested from the State of Indiana related to certain state tax apportionment provisions in the Indiana Financial Institution Tax Code and Regulations. The advisory letter provided guidance related to the methodology used to determine and source the receipts in the state of Indiana for the Company’s mortgage origination and warehousing service lines. In effect, the guidance provided the Company the ability to revise its state income tax apportionment calculation to reduce its Indiana tax and related deferred tax liabilities. As such, the Company will amend several of its state returns and request the respective refunds. In anticipation of the refunds, a receivable was established as of June 30, 2023. On July 21, 2023, the company received a final revenue ruling from the Indiana Department of Revenue supporting the revised methodology. Additionally, the change in methodology is expected to result in a 1.0% to 1.5% reduction in the Company’s overall effective tax rate in the future.

The effective tax rate was 15.2% for the six months ended June 30, 2023 and 25.1% for the six months ended June 30, 2022.

Our Segments

We operate in three primary segments: Multi-Family Mortgage Banking, Mortgage Warehousing, and Banking. The reportable segments are consistent with the internal reporting and evaluation of the principal lines of business of the

Company. The Multi-family Mortgage Banking segment originates and services government sponsored mortgages for multi-family and healthcare facilities. It is also a fully integrated syndicator of low-income housing tax credit and debt funds. As one of the top ranked agency lenders in the nation, our licenses with Fannie Mae, Freddie Mac, and FHA, coupled with our bank financing products, provide sponsors custom beginning-to-end financing solutions that adapt to an ever-changing market. We are also one of the largest GNMA servicers in the country based on aggregate loan principal value. As of June 30, 2023 the Company’s total servicing portfolio had an unpaid principal balance of $23.5 billion, primarily managed in the Multi-Family Mortgage Banking segment. Included in this amount was an unpaid principal balance of loans serviced for others of $13.8 billion, an unpaid principal balance of loans sub-serviced for others of $2.1 billion, and other servicing balances of $0.7 billion at June 30, 2023. These loans are not included in the accompanying balance sheets. The Company also manages $7.0 billion of loans for customers that have loans on the balance sheet at June 30, 2023. The servicing portfolio is primarily GNMA, Fannie Mae, and Freddie Mac loans and is a significant source of our noninterest income and deposits.

Our Mortgage Warehousing segment funds agency eligible loans for non-depository financial institutions from the date of origination or purchase until the date of sale to an investor, which typically takes less than 30 days and is a significant source of our net interest income, loans, and deposits. Mortgage Warehousing has grown to fund over $78 billion in 2021, $33.2 billion in 2022, and $13.8 billion for the six months ended June 30, 2023. Mortgage Warehousing also provides commercial loans secured by GNMA, Fannie Mae, and Freddie Mac servicing rights and collects deposits related to the mortgage escrow accounts of its customers. Merchants was recently ranked as the third largest producer of warehouse commitments by Inside Mortgage Finance.

The Banking segment includes retail banking, commercial lending, agricultural lending, retail and correspondent residential mortgage banking, and SBA lending. Banking operates primarily in Indiana and Illinois, except for correspondent mortgage banking which, like Multi-family Mortgage Banking and Mortgage Warehousing, is a national business. The Banking segment has a well-diversified customer and borrower base and has experienced significant growth over the past three years.

Our segments diversify the net income of Merchants Bank and provide synergies across the segments. The strategic opportunities include that MCC loans are funded by Merchants Banking segment and the Banking segment provides GNMA custodial services to MCC. The securities available for sale funded by MCC custodial deposits, as well as loans generated by Merchants Bank, are pledged to the FHLB to provide advance capacity during periods of high residential loan volume for Mortgage Warehousing. Mortgage Warehousing provides leads to correspondent residential lending in the banking segment. MCC also provides leads to Merchants Bank for core deposit opportunities. Retail and commercial customers provide cross selling opportunities within the banking segment. These and other synergies form a part of our strategic plan.

For the three months ended June 30, 2023 and 2022, we had total net income of $65.3 million and $53.9 million, respectively. For the six months ended June 30, 2023 and 2022, we had total net income of $120.3 million and $104.1 million, respectively. Net income for our three segments for the respective periods was as follows:

(In thousands)

Multi-family Mortgage Banking.

Comparison of results for the three months ended June 30, 2023 and 2022:

The Multi-family Mortgage Banking segment reported net income of $11.2 million for the three months ended June 30, 2023, a decrease of $8.3 million, or 43%, compared to the three months ended June 30, 2022. The decrease was primarily due to a $19.2 decrease in gain on sale of loans, partially offset by a $6.8 million decrease in the provision for income tax that reflected a tax benefit for tax refunds receivable and changes to state tax apportionment calculations.

Also included in the results was a $2.4 million increase in syndication and asset management fees that was partially offset by a $50,000 decrease in loan servicing fees that reflected higher underlying growth offset by lower positive fair market value adjustments. The decrease in loan servicing fees reflected a positive fair market value adjustment of $2.1 million on servicing rights for the three months ended June 30, 2023 compared to a positive fair market value adjustment of $6.6 million for the three months ended June 30, 2022.

The volume of loans originated and acquired for sale in the secondary market increased by $261.8 million, or 64%, to $668.2 million, for the three months ended June 30, 2023, compared to $406.4 million for the three months ended June 30, 2022.

Comparison of results for the six months ended June 30, 2023 and 2022:

The Multi-family Mortgage Banking segment reported net income of $13.2 million for the six months ended June 30, 2023, a decrease of $17.8 million, or 57%, from the $31.0 million of net income reported for the six months ended June 30, 2022. The decrease was primarily due to a $34.7 million decrease in noninterest income, including a $32.1 million decrease in gain on sale of loans and a $1.3 million decrease in loan servicing fees. The decrease in loan servicing fees reflected a negative fair market value adjustment of $0.1 million on servicing rights for the six months ended June 30, 2023 compared to a positive fair market value adjustment of $9.9 million for the six months ended June 30, 2022.

The lower noninterest income was partially offset by a $10.1 million decrease in the provision for income tax that was associated with a tax benefit for tax refunds receivable and changes to state tax apportionment calculations, as well as lower commission expenses associated with lower gain on sale for the six months ended June 30, 2023.

The volume of loans originated and acquired for sale in the secondary market decreased by $165.7 million, or 17%, to $782.3 million, for the six months ended June 30, 2023 compared to the six months ended June 30, 2022.

Mortgage Warehousing.

Comparison of results for the three months ended June 30, 2023 and 2022:

The Mortgage Warehousing segment reported net income of $18.6 million for the three months ended June 30, 2023, an increase of $6.7 million, or 57%, compared to the three months ended June 30, 2022. The higher net income reflected a $41.0 million increase in interest income primarily from higher yields and volumes on revolving lines of credit that are collateralized by mortgage servicing rights, as well as a decrease of $4.3 million in the provision for income tax that included a tax benefit for tax refunds receivable and changes to state tax apportionment calculations. Mortgage warehouse fees also increased by $1.5 million. These increases to net income were partially offset by a $37.4 million increase in interest expenses that reflected higher costs of deposits, a $1.5 million increase in the provision for credit losses, and a $0.8 million increase in deposit insurance expenses.

There was a 5% decrease in warehouse loan volume of $8.4 billion compared to $8.8 billion for the three months ended June 30, 2022, which compared to an industry volume decrease of 32%, according to the Mortgage Bankers Association.

Comparison of results for the six months ended June 30, 2023 and 2022:

The Mortgage Warehousing segment reported net income for the six months ended June 30, 2023 of $27.2 million, an increase of $2.2 million, or 9%, over the $25.0 million reported for the six months ended June 30, 2022. The higher net income was primarily due to a $63.0 million increase in interest income associated with higher yields and volume on revolving lines of credit that are collateralized by mortgage servicing rights, as well as a decrease of $5.7 million in the provision for income tax that reflected a tax benefit for tax refunds receivable and changes to state tax apportionment calculations. Mortgage warehouse fees also increased by $0.7 million. These increases to net income were partially offset by a $63.2 million increase in interest expenses that reflected higher costs of deposits, a $3.1 million increase in the provision for credit losses, and a $1.1 million increase in deposit insurance expenses.

There was a 24% decrease in warehouse loan volume of $13.8 billion compared to $18.2 billion for the six months ended June 30, 2022, which compared to an industry volume decrease of 42%, according to the Mortgage Bankers Association.

Banking.

Comparison of results for the three months ended June 30, 2023 and 2022:

The Banking segment reported net income of $42.7 million for the three months ended June 30, 2023, an increase of $16.7 million, or 64%, compared to the three months ended June 30, 2022. The increase was primarily due to a $28.6 million increase in net interest income, a $9.0 million increase in gain on sale of loans, and a $4.2 million decrease in the provision for income taxes, partially offset by a $16.1 million increase in the provision for credit losses and a $5.4 million increase in salaries and employee benefits.

Noninterest income for the three months ended June 30, 2023 included a positive fair market value adjustment of $1.3 million on single-family servicing rights, compared to a positive fair market value adjustment of $1.2 million for the three months ended June 30, 2022.

Comparison of results for the six months ended June 30, 2023 and 2022:

The Banking segment reported net income of $92.0 million for the six months ended June 30, 2023, an increase of $37.3 million, or 68%, compared to $54.7 million for the six months ended June 30, 2022. The increase was primarily due to a $65.5 million increase in net interest income and a $10.7 million increase in gain on sale of loans, partially offset by an $18.9 million increase in the provision for credit losses, a $7.8 million increase in salaries and employee benefits, a $5.1 million decrease in loan servicing fees, and a $3.5 million increase in deposit insurance expense that, reflected growth in assets and deposits.

Noninterest income for the six months ended June 30, 2023 included a positive fair market value adjustment of $0.6 million on single-family servicing rights, compared to a positive fair market value adjustment of $5.5 million for the six months ended June 30, 2022.

Liquidity and Capital Resources

Liquidity.

Our primary sources of funds are business and consumer deposits, escrow and custodial deposits, brokered deposits, borrowings, principal and interest payments on loans, and proceeds from sale of loans. While maturities and scheduled amortization of loans are predictable sources of funds, deposit flows and mortgage prepayments are greatly influenced by market interest rates, economic conditions, and competition.

At June 30, 2023, based on available collateral, we had $5.3 billion in available unused borrowing capacity with the FHLB and the Federal Reserve discount window. While the amounts available fluctuate daily, we also had available capacity in credit lines through our membership in the AFX. This liquidity enhances the ability to effectively manage interest expense and asset levels in the future.

The Company’s most liquid assets are in cash, short-term investments, including interest-bearing demand deposits, mortgage loans in process of securitization, loans held for sale, and warehouse lines of credit included in loans receivable. Taken together with its unused borrowing capacity of $5.3 billion described below, these totaled $10.2 billion, or 64%, of its $15.9 billion total assets at June 30, 2023. The levels of these assets are dependent on our operating, financing, lending, and investing activities during any given period.

Our liquid assets and borrowing capacity significantly exceed our uninsured deposits. Uninsured deposits totaled approximately $2 billion as of June 30, 2023, representing less than 20% of total deposits. Since 2018, the Company has offered its customers an opportunity to insure balances in excess of $250,000 through our insured cash sweep program that extends FDIC protection up to $100 million. The balance of deposits in this program was $1.7 billion as of June 30, 2023.

The Company’s investment portfolio has minimal levels of unrealized losses and management does not anticipate a need to sell securities for liquidity purposes at a loss. We are able to maintain minimal levels of investment securities because of our originate to sell model, which provides ongoing liquidity. As of June 30, 2023, Accumulated Other Comprehensive Losses (“AOCL”) of $7.0 million losses, related to securities available for sale, decreased $3.5 million, or 33%, compared to losses of $10.5 million as of December 31, 2022. The $7.0 million loss in AOCL as of June 30, 2023 represented less than 1% of total equity and 1% of total securities available for sale.

Our cash flows are comprised of three primary classifications: cash flows from operating activities, investing activities, and financing activities. Net cash (used in) provided by operating activities was $(543.0) million and $874.8 million for the six months ended June 30, 2023 and 2022, respectively. Net cash (used in) investing activities, which consists primarily of net change in loans receivable and purchases, sales and maturities of investment securities and loans, was $(2.4) billion and $(1.4) billion for the six months ended June 30, 2023 and 2022, respectively. Net cash provided by (used in) financing activities, which is comprised primarily of net change in borrowings and deposits was $3.1 billion and $(297.4) million for the six months ended June 30, 2023 and 2022, respectively.

At June 30, 2023 we had $3.5 billion in outstanding commitments to extend credit that are subject to credit risk and $3.7 billion outstanding commitments subject to certain performance criteria and cancellation by the Company, including loans pending closing, unfunded construction draws, and unfunded lines of warehouse credit. We anticipate that we will have sufficient funds available to meet our current loan origination commitments.

Certificates of deposit that are scheduled to mature in less than one year from June 30, 2023 totaled $5.0 billion, or 97%, of total certificates of deposit. Management expects that a substantial portion of the maturing certificates of deposit will be renewed. However, if a substantial portion of these deposits is not retained, we may decide to utilize FHLB advances, the Federal Reserve discount window, brokered deposits, or raise interest rates on deposits to attract new accounts, which may result in higher levels of interest expense.

In the normal course of operations, we engage in a variety of financial transactions that, in accordance with U.S. generally accepted accounting principles, are not recorded in our financial statements. These transactions involve, to varying degrees, elements of credit, interest rate and liquidity risk. Such transactions are used primarily to manage customers’ requests for funding and take the form of loan commitments, lines of credit and standby letters of credit.

Capital Resources.

The access to and cost of funding for new business initiatives, the ability to engage in expanded business activities, the ability to pay dividends, the level of deposit insurance costs and the level and nature of regulatory oversight depend, in part, on our capital position. The Company filed a shelf registration statement on Form S-3 with the SEC on August 8, 2022, which was declared effective on August 17, 2022, under which we can issue up to $500 million aggregate offering amount of registered securities to finance our growth objectives. As previously demonstrated, the Company also has the ability to utilize securitization transactions to free up capital as needed.

The assessment of capital adequacy depends on a number of factors, including asset quality, liquidity, earnings performance, changing competitive conditions and economic forces. We seek to maintain a strong capital base to support our growth and expansion activities, to provide stability to our current operations and to promote public confidence in our Company.

Shareholders’ Equity. Shareholders’ equity was $1.6 billion as of June 30, 2023, compared to $1.5 billion as of December 31, 2022. The $100.6 million increase resulted primarily from net income of $120.3 million, which was partially offset by dividends paid on common and preferred shares of $24.3 million during the period.

7% Series A Preferred Stock. In March 2019 the Company issued 2,000,000 shares of 7.00% Fixed-to-Floating Rate Series A Non-Cumulative Perpetual Preferred Stock, without par value, and with a liquidation preference of $25.00 per share (“Series A Preferred Stock”). The Company received net proceeds of $48.3 million after underwriting discounts, commissions and direct offering expenses. In April 2019, the Company issued an additional 81,800 shares of Series A Preferred Stock to the underwriters related to their exercise of an option to purchase additional shares under the associated underwriting agreement, resulting in an addition $2.0 million in net proceeds, after underwriting discounts.

In June 2019 the Company issued an additional 874,000 shares of Series A Preferred Stock for net proceeds of $21.85 million.

In September 2019 the Company repurchased and subsequently retired 874,000 shares of Series A Preferred Stock at an aggregate cost of $21.85 million. There were no brokerage fees in connection with the transaction.

Dividends on the Series A Preferred Stock, to the extent declared by the Company’s board, are payable quarterly at an annual rate of $1.75 per share through March 31, 2024. After such date, quarterly dividends were to accrue and be payable at a floating rate equal to three-month LIBOR plus a spread of 460.5 basis points per year. However, the terms of the Series A Preferred Stock permit us to replace three-month LIBOR if we determine that LIBOR has been discontinued or is no longer viewed as an acceptable benchmark for similar securities. With the cessation of published three-month LIBOR rates as of June 30, 2023, the Company has determined that three-month LIBOR has been discontinued and is no longer an acceptable benchmark. The Company anticipates replacing three-month LIBOR with Federal Reserve’s three month Secured Overnight Financing Rate (“SOFR”). The Company believes that three-month SOFR represents the most comparable replacement benchmark, is an industry-accepted substitute, and is consistent with expectations of investors in securities similar to the Series A Preferred Stock. In addition to replacing three-month LIBOR with three-month SOFR, the terms of the Series A Preferred Stock permit us to adjust the spread to ensure that the payable floating rate remains comparable. Therefore, the Company anticipates increasing the spread by 26.2 basis points, which is consistent with industry practice and the recommendation of the Federal Reserve’s Alternative Reference Rates Committee, resulting in the Company paying a floating rate of three-month SOFR plus a spread of 486.7 basis points during the floating rate period. The Company may also redeem the Series A Preferred Stock at its option, subject to regulatory approval, on or after April 1, 2024.

6% Series B Preferred Stock. In August 2019 the Company issued 5,000,000 depositary shares, each representing a 1/40th interest in a share of its 6.00% Fixed-to-Floating Rate Series B Non-Cumulative Perpetual Preferred Stock, without par value, and with a liquidation preference of $1,000.00 per share (equivalent to $25.00 per depositary share)(“Series B Preferred Stock”). After deducting underwriting discounts, commissions, and direct offering expenses, the Company received total net proceeds of $120.8 million.

Dividends on the Series B Preferred Stock, to the extent declared by the Company’s board, are payable quarterly at an annual rate of $60.00 per share (equivalent to $1.50 per depositary share) through September 30, 2024. After such date, quarterly dividends were to accrue and be payable at a floating rate equal to three-month LIBOR plus a spread of 456.9 basis points per year. However, the terms of the Series B Preferred Stock permit us to replace three-month LIBOR if we determine that LIBOR has been discontinued or is no longer viewed as an acceptable benchmark for similar securities. With the cessation of published three-month LIBOR rates as of June 30, 2023, the Company has determined that three-month LIBOR has been discontinued and is no longer an acceptable benchmark. The Company anticipates replacing three-month LIBOR with Federal Reserve’s three month Secured Overnight Financing Rate (“SOFR”). The Company believes that three-month SOFR represents the most comparable replacement benchmark, is an industry-accepted substitute, and is consistent with expectations of investors in securities similar to the Series B Preferred Stock. In addition to replacing three-month LIBOR with three-month SOFR, the terms of the Series B Preferred Stock permit us to adjust the spread to ensure that the payable floating rate remains comparable. Therefore, the Company anticipates increasing the spread by 26.2 basis points, which is consistent with industry practice and the recommendation of the Federal Reserve’s Alternative Reference Rates Committee, resulting in the Company paying a floating rate of three-month SOFR plus a spread of 483.1 basis points during the floating rate period. The Company may also redeem the Series B Preferred Stock at its option, subject to regulatory approval, on or after April 1, 2024.

6% Series C Preferred Stock. On March 23, 2021, the Company issued 6,000,000 depositary shares, each representing a 1/40th interest in a share of its 6.00% Fixed Rate Series C Non-Cumulative Perpetual Preferred Stock, without par value (the “Series C Preferred Stock”), and with a liquidation preference of $1,000.00 per share (equivalent to $25.00 per depositary share). The aggregate gross offering proceeds for the shares issued by the Company was $150.0 million, and after deducting underwriting discounts and commissions and offering expenses of approximately $5.1 million paid to third parties, the Company received total net proceeds of $144.9 million.

On May 6, 2021, our previously issued, 8% preferred shareholders participated in a private offering to replace their redeemed 8% preferred shares with the Company’s 6% Series C preferred stock. Accordingly, 46,181 shares (1,847,233 depositary shares) of the Company’s 6% Series C preferred stock were issued at a price of $25 per depositary share. The total capital raised from the private offering was $46.2 million, net of $23,000 in expenses.

Dividends on the Series C Preferred Stock, to the extent declared by the Company’s board, are payable quarterly. The Company may redeem the Series C Preferred Stock, in whole or in part, at our option, on any dividend payment date on or after April 1, 2026, subject to the approval of the appropriate federal banking agency, at the liquidation preference, plus any declared and unpaid dividends (without regard to any undeclared dividends) to, but excluding, the date of redemption.

8.25% Series D Preferred Stock. On September 27, 2022, the Company issued 5,200,000 depositary shares, each representing a 1/40th interest in a share of its 8.25% Fixed Rate Series D Non-Cumulative Perpetual Preferred Stock, without par value (the “Series D Preferred Stock”), and with a liquidation preference of $1,000.00 per share (equivalent to $25.00 per depositary share). The aggregate gross offering proceeds for the shares issued by the Company was $130.0 million, and after deducting underwriting discounts and commissions and offering expenses of approximately $4.6 million paid to third parties, the Company received total net proceeds of $125.4 million. On September 30, 2022, the Company issued an additional 500,000 shares of Series D Preferred Stock to the underwriters related to their exercise of an option to purchase additional shares under the associated underwriting agreement, resulting in an additional $12.1 million in net proceeds, after deducting $0.4 million in underwriting discounts.

Dividends on the Series D Preferred Stock, to the extent declared by the Company’s board, are payable quarterly. The Company may redeem the Series D Preferred Stock, in whole or in part, at our option, on any dividend payment date on or after October 1, 2027, subject to the approval of the appropriate federal banking agency, at the liquidation preference, plus any declared and unpaid dividends (without regard to any undeclared dividends) to, but excluding, the date of redemption.

Common Shares/Dividends. As of June 30, 2023, the Company had 43,237,300 common shares issued and outstanding. The Board expects to declare a quarterly dividend of $0.08 per share in each quarter of 2023.

Capital Adequacy.

The following tables present the Company’s capital ratios at June 30, 2023 and December 31, 2022:

(Dollars in thousands)

(1) As defined by regulatory agencies.

(Dollars in thousands)

(1) As defined by regulatory agencies.

Quantitative measures established by regulation to ensure capital adequacy require the Company, Merchants Bank, and FMBI to maintain minimum amounts and ratios. Management believes, as of June 30, 2023 and December 31, 2022, that the Company, Merchants Bank, and FMBI met all capital adequacy requirements to which they were subject.

As of June 30, 2023 and December 31, 2022, the most recent notifications from the Federal Reserve categorized the Company as well capitalized and most recent notifications from the FDIC categorized Merchants Bank and FMBI as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the Company’s, Merchants Bank’s, or FMBI’s category.

Quantitative and Qualitative Disclosures About Market Risk

Market Risk. Market risk represents the risk of loss due to changes in market values of assets and liabilities. We incur market risk in the normal course of business through exposures to market interest rates, equity prices, and credit spreads. We have identified two primary sources of market risk: interest rate risk and price risk related to market demand.

Interest Rate Risk

Overview. Interest rate risk is the risk to earnings and value arising from changes in market interest rates. Interest rate risk arises from timing differences in the repricings and maturities of interest-earning assets and interest-bearing liabilities (reprice risk), changes in the expected maturities of assets and liabilities arising from embedded options, such as borrowers’ ability to prepay residential mortgage loans at any time and depositors’ ability to redeem certificates of deposit before maturity (option risk), changes in the shape of the yield curve where interest rates increase or decrease in a nonparallel fashion (yield curve risk), and changes in spread relationships between different yield curves, such as U.S. Treasuries or SOFR.

Our business consists primarily of funding fixed rate, low risk, multi-family, residential and SBA loans meeting underwriting standards of government programs under an originate to sell model, and retaining adjustable rate loans as held for investment to reduce interest rate risk.

Our Asset-Liability Committee, or ALCO, is a management committee that manages our interest rate risk within broad policy limits established by our board of directors. In general, we seek to minimize the impact of changing interest rates on net interest income and the economic values of assets and liabilities. Our ALCO meets quarterly to monitor the level of interest rate risk sensitivity to ensure compliance with the board of directors’ approved risk limits.

Interest rate risk management is an active process that encompasses monitoring loan and deposit flows complemented by investment and funding activities. Effective management of interest rate risk begins with understanding the dynamic characteristics of assets and liabilities and determining the appropriate interest rate risk posture given business forecasts, management objectives, market expectations, and policy constraints.

An asset sensitive position refers to a balance sheet position in which an increase in short-term interest rates is expected to generate higher net interest income, as rates earned on our interest-earning assets would reprice upward more quickly than rates paid on our interest-bearing liabilities, thus expanding our net interest margin. Conversely, a liability sensitive position refers to a balance sheet position in which an increase in short-term interest rates is expected to generate lower net interest income, as rates paid on our interest-bearing liabilities would reprice upward more quickly than rates earned on our interest-earning assets, thus compressing our net interest margin.

Income Simulation and Economic Value Analysis. Interest rate risk measurement is calculated and reported to the ALCO at least quarterly. The information reported includes period-end results and identifies any policy limits exceeded, along with an assessment of the policy limit breach and the action plan and timeline for resolution, mitigation, or assumption of the risk.

We use two approaches to model interest rate risk: Net Interest Income at Risk (NII at Risk) and Economic Value of Equity (“EVE”). Under NII at Risk, net interest income is modeled utilizing various assumptions for assets, liabilities, and derivatives and excludes non-interest income. EVE measures the period end market value of assets minus the market value of liabilities and the change in this value as rates change. EVE is a period end measurement.

We report NII at Risk to isolate the change in income related solely to interest-earning assets and interest-bearing liabilities. The NII at Risk results reflect the analysis used quarterly by management. It models gradual -200, -100, +100 and +200 basis point parallel shifts in market interest rates, implied by the forward yield curve over the next one-year period.

The following table presents NII at Risk for Merchants Bank as of June 30, 2023 and December 31, 2022.

Our interest rate risk management policy limits the change in our net interest income to 20% for a +/- 100 basis point move in interest rates, and 30% for a +/- 200 basis point move in rates. At June 30, 2023 we estimated that we are within policy limits set by our board of directors for the -200, -100, +100, and +200 basis point scenarios.

The EVE results for Merchants Bank included in the following table reflect the analysis used quarterly by management. It models immediate -200, -100, +100 and +200 basis point parallel shifts in market interest rates.

Our interest rate risk management policy limits the change in our EVE to 15% for a +/- 100 basis point move in interest rates, and 20% for a +/- 200 basis point move in rates. We are within policy limits set by our board of directors for the -200, -100, +100 and +200 basis point scenarios. The EVE reported at June 30, 2023 projects that as interest rates increase (decrease) immediately, the economic value of equity position will be expected to decrease (increase). When interest rates rise, fixed rate assets generally lose economic value; the longer the duration, the greater the value lost. The opposite is true when interest rates fall.

The information required under this item is included as part of “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Form 10-Q under the headings “Liquidity and Capital Resources” and “Interest Rate Risk.”

(a) Evaluation of disclosure controls and procedures.

Our management, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this Form 10-Q. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that, as of June 30, 2023, the Company’s disclosure controls and procedures were effective.

(b) Changes in internal control.

There have been no changes in the Company's internal control over financial reporting during the period covered by this report that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

Part II

Other Information

There have been no material changes from the risk factors previously disclosed in the “Risk Factors” section included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2022.