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First Financial BancorpTrue Stories. M E R C A N T I L E B A N K C O R P O R AT I O N 2 0 0 6 A N N U A L R E P O R T Name Recognition L e t t e r t o S h a r e h o l d e r s “As soon as any customer walks through that door, they’re greeted by name,” declares Jackie Jones, pointing to the entrance of Mercantile Bank - Kentwood. Jackie Jones Customer Specialist Kentwood We all have a story to tell. At Mercantile Bank, our stories revolve around our customers and the communities we serve: The new mother whose day we brightened with a simple courtesy. The business owner whose future we changed with a word of advice. The children whose lives we enriched with an investment of time and attention. These are the tales we tell each other over coffee breaks and lunches, while sharing a ride to work or pitching in on a charity project. Individually, these stories reflect the character of the people who work at Mercantile. Collectively, they illustrate the service commitment that has It’s a welcome touch at a time always set Mercantile apart. when service elsewhere has become increasingly impersonal and We thought we’d share just a few of the indifferent. “People really appreciate past year’s stories with you in this report to it when we immediately set aside our paperwork and say hello. It makes them feel special. And the our shareholders. We know you’ll be gratified that each story personal connection we make with concludes with the same happy ending: customers makes us want to work even harder for them.” 2006 was another excellent year for the Corporation and its shareholders. 2 Reaching $2 Billion In Assets In September, 2006, Mercantile Bank reached another notable milestone, as we surpassed $2 billion in assets. This was accomplished in little more than three years after passing the $1 billion mark – another extraordinary achievement. Less than a decade ago, the founders of Mercantile Bank were sitting around a kitchen table, strategizing ways to position our soon-to-debut enterprise against the larger banks that dominated the West Michigan landscape. Today, we are one of those “larger” banks. In fact, as of June 30, 2006, we ranked 292nd in assets out of more than 7,700 banks nationwide. That puts us in the top 4% of all banks across the country. Closer to home, we ranked as the 9th largest Michigan-based bank in the state. This was also as of June 30, 2006, in a universe of 173 state-based financial institutions. Our market status is even more impressive locally. We are now number two in market share in the Grand Rapids Metropolitan Statistical Area. We’ve attained this significant market position in less than 10 years, with just 8 locations – 6 in West Michigan. Back to School Mercantile Bank - Lansing has partnered with an inner-city school, Moores Park Elementary, to help teach kids the importance of saving and budgeting. The entire Mercantile staff worked to set up the bank and Cassy Puskala Assistant Branch Manager Lansing This significant growth is a direct result of the decisions made around that kitchen table in 1997. We determined that we would train student “employees.” Students open accounts and save money to focus on business banking, limit brick-and-mortar expenses, and make purchases at an end-of-the- deliver an unprecedented level of customer service and community year book fair. Mercantile matches support. All of these, we felt, would maximize our growth potential the first $5.00 each student saves. and deliver superior returns to our shareholders. Obviously, we’ve been proven right. Now, as we enter our 10th year of operation, we are renewing the commitments we made at the beginning of our journey – most especially, our pledge to provide the very best service possible. “The teachers love it,” says Cassy Puskala. “They’re using it to help teach counting and math to the kids, who range from kindergartners to third graders.” 3 I Can Do That “Customers don’t expect me to have much authority in my position,” says Cesar Gonzales. “But at Mercantile, we’re all empowered to make decisions on the spot.” Cesar Gonzales Mortgage Operations Assistant Grand Rapids Growing Big, Acting Small We’ve all seen it: the business with an uncanny ability to satisfy customers grows larger and larger – and, in the process, seems to lose touch with its customers and their needs. This unfortunate scenario has become so prevalent in American business that our own customers and shareholders have joined financial analysts and journalists in raising it as a concern. How, they ask, will Mercantile retain its service culture as it grows larger and more geographically diverse? The answer lies in the stories of the Mercantile associates featured in these pages, and in many other stories we could print if we had the space. Yes, Mercantile is quickly becoming a “big” bank. But we still think and act as if we were an entrepreneurial upstart, striving to win the attention and loyalty of every single customer. We empower our front-line associates to make the kinds of decisions other banks reserve only for supervisors. We support our lenders in exploring every possible avenue to make a deal work. We encourage each other to volunteer time and talents to improve So when a customer called to the quality of life in the communities we serve. All of us work say she missed a deposit because long and hard to continually surprise and delight customers and she was in the hospital giving birth, potential customers alike. Cesar immediately waived the overdraft fee on a check. “Then she wanted to wait while I got approval from a manager,” Cesar grins. “It took me awhile to convince her I could do it myself!” We’re able to maintain this entrepreneurial zeal because of the measured and deliberate nature of our expansion. While other banks seek to accelerate growth by building an extensive branch network, we’ve chosen to minimize our physical infrastructure and build greater efficiencies into our rather non-traditional banking model. 4 Business Before Pleasure That means we’re not constantly hiring the first people Sandy Ross and several of her that come along to fill position after position at one branch office Mercantile Bank - Washtenaw colleagues after another. Instead, we have the luxury of taking our time to didn’t attend the bank’s holiday party last find the best of the best – talents who have already proven themselves elsewhere or who shine with uncommon intelligence, insight and ambition. This is just one more vindication of our original vision for Mercantile … and one more reason Mercantile will be able to continue “acting small” no matter how large we grow. New Challenges Emerge The kind of growth we’ve achieved does not go unnoticed. One very positive consequence is the attention of a broadening range of shareholders. One not-so-positive (but entirely expected) consequence is greater attention from our competitors. Competitive pressures were one of our main challenges in 2006. Local and regional banks continued to bid aggressively on existing and potential new Mercantile credit relationships – both with regard to pricing and deal structure. year. Instead, they volunteered at the 2006 Saline Holiday Parade, held the very same night. Sandy Ross Branch Manager Washtenaw Despite this, we remained committed to our traditional “Customers and community always high standards of loan underwriting. We believe the impact of come first for us,” says Sandy, who compromising our own proven pricing and underwriting standards recently served as chair of the parade could be detrimental to our ability to sustain our historically high organizer, the Saline Area Chamber levels of performance over the long term. We will always do everything we can to close a deal, but we will also walk away from any transactions we feel do not provide an adequate return for the risk involved or are structured in such a way that, in our opinion, the exposure to potential loss is unacceptable. of Commerce. “We missed celebrating with our friends at the bank, but we really feel we helped improve the quality of life for people here.” 5 Burning the Midnight Oil Mercantile offers the technology of The other key challenge we faced in 2006 was not unique a much larger bank – including a sophisticated payroll processing system. But all the technology in the world can’t force customers Mike Kroft eBanking Services Manager Grand Rapids to get their payroll file to us on time every week. “We don’t say, well, you’re out of luck because you missed our deadline,” Mike Kroft relates. “We work to make it happen, even if it means staying late or getting in early. We’ll manually create files to Mercantile. The entire banking industry has been, and is, contending with interest rate uncertainty and a somewhat unusual “inversion” of the normal relationship between short- and long-term interest rates. Under this interest rate scenario, short-term rates have been higher than long-term rates. This makes it much more difficult for most banks to maintain their margins – that is, the difference in interest earned on loans and investments and interest paid on deposits and other indebtedness. Even with increasing competitive pressures and interest rate challenges, even though we are operating in an economy that generally lags behind the rest of the nation, we are pleased to report that our strategy remains a winning one: Mercantile Bank once again grew earnings and assets at double-digit rates in 2006. Financials at a Glance Mercantile Bank achieved net income of $19.8 million in fiscal year 2006. This is an increase of 10.9% from the $17.9 million reported EARNINGS PER SHARE GROWTH SINCE 2002 6,371 6,853 8,108 8,137 8,112 $2.45 $2.20 $1.69 $1.46 if need be. Our customers aren’t $1.22 going to miss their payroll – not if we can help it!” 6 2002 2003 2004 2005 2006 Fully Diluted EPS Presented in Accordance with GAAP Average Shares Outstanding (000) Out of the Office for 2005. Diluted earnings per share were $2.45, an increase of Keane Blaszczynski and his fellow 11.4% from the $2.20 reported for the prior year. Earnings benefited from solid loan growth, most notably in our “new” markets of Ann Arbor, Holland and Lansing. These markets were responsible for 50% of our net new loan growth for the year and 41% of our net new local deposit growth. They have proven to be strong complements to our Kent County franchise. ANNUAL ASSET ENDING BALANCES SINCE 2002 (000) Mercantile lenders spend a lot of time out of the office. No, they’re not on the golf course: “We’re constantly doing customer tours,” he says, “checking in to see how $2,200,000 $2,000,000 $1,800,000 $1,600,000 $1,400,000 $1,200,000 $1,000,000 $800,000 $600,000 $400,000 $200,000 $0 2 0 / 1 3 / 2 1 3 0 / 1 3 / 2 1 4 0 / 1 3 / 2 1 5 0 / 1 3 / 2 1 6 0 / 1 3 / 2 1 Total revenue, comprised of net interest income and non-interest income, was $66.8 million for 2006, an increase of 9.7% over the $61.0 million reported in the previous year. Net Keane Blaszczynski Vice President, Commercial Lender Grand Rapids interest income increased 11.4% year over year to $61.6 million, they’re doing and how else we reflecting average earning asset growth of 15.3%. This was partially can help.” offset by a 13 basis point decline in net interest margin to 3.37%. Non-interest income for the year was $5.3 million, compared with $5.7 million for 2005. However, approximately $0.7 million of the 2005 fee income represented a one-time gain on the fourth-quarter 2005 sale of state tax credits derived from the construction of our new headquarters building. Subtracting this gain from the equation results in a year-to-year gain in fee income. Customers are surprised and gratified by the continued interest. “They’ve worked with other banks that just sit back and collect loan payments.They appreciate that we really care about their success.” 7 Now We’re Cookin’ Kitty Arbanas is a member of We continue to leverage our investment in infrastructure, “Team Gordon,” the seven-person support staff for Commercial Lender Gordon Oosting. “We’re all cross-trained so we can pinch-hit Kitty Arbanas Loan Administration Team Leader/Officer Grand Rapids supporting additional loan growth while maintaining operating expense at a relatively stable level throughout the year. For 2006, our efficiency ratio (the cost of generating $1.00 of net revenue – so lower is better) averaged 48.3%, compared to 51.1% in 2005. This ratio was below 50% for each of the four quarters of 2006. Non-interest expense was $32.3 million for 2006, a modest increase of 3.7% over fiscal year 2005; this compares with a year-over-year asset growth of 12.5%. Salaries and benefits, the largest component of non-interest expense, was $19.0 million, an increase of 1.9% over the prior year. While asset quality remained relatively stable throughout the year, net loan charge-offs for 2006 were $4.9 million, equivalent to 0.29% of average loans. This compares to $1.1 million or 0.08% of average loans for the prior year. Non-performing assets were $9.6 million, or 0.46% of total assets at December 31, 2006, compared with $4.0 million, or 0.22% of total assets, at December 31, 2005. These figures are historically high for Mercantile, but they still compare favorably with what is happening both nationally and for each other – we never have within our Michigan peer group. FDIC statistics for all insured to tell a customer to call back banks reflect non-performing assets of 0.49% of total assets tomorrow because so-and-so’s (as of September 30, 2006). A peer group of 40 publicly traded out of the office.” The team’s well-oiled interaction came in handy when they worked together to prepare a meal for 50 people at Gilda’s Club, a support community for people with cancer. “We made 104 meatballs – and they were gone in 10 minutes!” 8 Michigan banks had non-performing assets of 0.66% of total assets (again, as of September 30, 2006). We’ve made a return to our customary high levels of asset quality a top corporate priority for the coming year. Total assets grew $229.1 million, or 12.5%, over the past 12 months, reaching $2.07 billion at December 31, 2006. Earning Stress Relief asset growth was $204.2 million, or 11.7%, during this period. “I see 25-35 customers a day,” Loans increased by $183.7 million, or 11.8%. Again, these results says Gene Naylor, “and I get to compare extremely well to our peer group. As a result of our excellent financial performance, Mercantile Bank Corporation paid an annual cash dividend of $0.51 per share on the company’s common stock during 2006, compared to the $0.43 per share paid in 2005. This represents a year-over-year dividend increase of $0.08 per share, or 18.6%. A New Chapter Begins Although 2006 was an extremely challenging year, we affirmed our ability to provide superior results in a difficult operating environment. We dealt very efficiently and effectively with the numerous challenges we faced, and we positioned the bank for another competitive year in 2007. Highlights of the coming year will include the completion of construction on our new Lansing office. Our associates and customers are looking forward to the move from our current space to this larger, more user-friendly building. The office is slated for a spring grand opening. We are also currently in the process of introducing our next-generation Internet banking platform. Cutting-edge technology is an essential part of our business plan, as it makes banking convenient to all, and lessens the need for new branch offices. Our new Internet product adds features and functionalities that will enable us to grow this avenue of know them in their natural settings. So I can tell when something’s bothering them. I try to give them a lift – thanking them for their Gene Naylor Courier, Special Services Department Grand Rapids business, asking if there’s anything else we can do for them … I’ve even helped solve some debit/credit issues on the spot.” Easing the stress of customers has done wonders for Gene, too: “My stress test is better now than when I was ‘retired’ – before I banking for Mercantile customers. started this job!” 9 Attitude is Everything Kyle Erickson thought he’d seen it all after 15 years in the banking industry. “But until I joined Mercantile, I’d never seen Kyle Erickson Vice President, Commercial Lender Holland an entire organization, from front line to back room, so totally focused on taking care of customers.” It’s not just a can-do kind of place – it’s will do and gladly so. “I tell my customers, if you’re L-R: Chuck Christmas, Jerry Johnson, Mike Price, Bob Kaminski We want to thank all of our Mercantile associates, as well as the members of our Board of Directors, for their efforts in 2006. Each of them has made a singular contribution to our success. Of course, we couldn’t have done it without the support of having a bad day, just stop into one our shareholders. We thank you, and invite you to join us as we write of our branches. The positive attitude is so infectious, you’ll leave smiling – I guarantee it.” the next chapter in the story of Mercantile Bank. Gerald R. Johnson, Jr. Chairman Chief Executive Officer Michael H. Price President Chief Operating Officer Robert B. Kaminski, Jr. Executive Vice President Secretary Charles E. Christmas Senior Vice President Chief Financial Officer and Treasurer 10 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 _____________ FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from __________________ to ____________________________ For the fiscal year ended December 31, 2006 or Commission file number 000-26719 MERCANTILE BANK CORPORATION (Exact name of registrant as specified in its charter) Michigan (State or other jurisdiction of incorporation or organization) 38-3360865 (I.R.S. Employer Identification No.) 310 Leonard Street NW, Grand Rapids, Michigan (Address of principal executive offices) 49504 (Zip Code) (616) 406-3000 (Registrant’s telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: Title of each class Common Stock Name of each exchange on which registered The Nasdaq Stock Market LLC Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes No X Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes No X Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No __ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non- accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. Large accelerated filer ___ Accelerated filer X Non-accelerated filer ___ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes No X The aggregate value of the common equity held by non-affiliates (persons other than directors and executive officers) of the registrant, computed by reference to the average of the closing bid and asked prices of the common stock as of the last business day of the registrant’s most recently completed second fiscal quarter, was approximately $290.6 million. As of February 12, 2007, there were issued and outstanding 8,027,853 shares of the registrant’s common stock. DOCUMENTS INCORPORATED BY REFERENCE Portions of the proxy statement for the 2007 annual meeting of shareholders (Portions of Part III). ITEM 1. BUSINESS The Company PART I Mercantile Bank Corporation is a registered bank holding company under the Bank Holding Company Act of 1956, as amended (the “Bank Holding Company Act”). Unless the text clearly suggests otherwise, references to “us,” “we,” “our,” or “the company” include Mercantile Bank Corporation and its wholly-owned subsidiaries. As a bank holding company, we are subject to regulation by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”). We were organized on July 15, 1997, under the laws of the State of Michigan, primarily for the purpose of holding all of the stock of Mercantile Bank of Michigan (“our bank”), and of such other subsidiaries as we may acquire or establish. Our bank commenced business on December 15, 1997. Mercantile Bank Mortgage Company initiated business in October 2000 as a subsidiary of our bank, and was reorganized as Mercantile Bank Mortgage Company, LLC (“our mortgage company”), on January 1, 2004. Mercantile Insurance Center, Inc. (“our insurance company”), a subsidiary of our bank, commenced operations during 2002 to offer insurance products. Mercantile Bank Real Estate Co., L.L.C., (“our real estate company”), a subsidiary of our bank, was organized on July 21, 2003, principally to develop, construct and own our new facility in downtown Grand Rapids which serves as our bank’s new main office and Mercantile Bank Corporation’s headquarters. Mercantile Bank Capital Trust I (the “Mercantile trust”), a business trust subsidiary, was formed in September 2004 to issue trust preferred securities. To date we have raised capital from our initial public offering of common stock in October 1997, a public offering of common stock in July 1998, three private placements of common stock during 2001, a public offering of common stock in August 2001 and a public offering of common stock in September 2003. In addition, we raised capital through a public offering of $16.0 million of trust preferred securities in 1999, which was refinanced as part of a $32.0 million private placement of trust preferred securities in 2004. Our expenses have generally been paid using the proceeds of the capital sales and dividends from our bank. Our principal source of future operating funds is expected to be dividends from our bank. We filed an election to become a financial holding company, pursuant to the Bank Holding Company Act, as amended by Title I of the Gramm-Leach-Bliley Act and implementing Federal Reserve Board regulations, which election became effective March 23, 2000. Our Bank Our bank is a state banking company that operates under the laws of the State of Michigan, pursuant to a charter issued by the Michigan Office of Financial and Insurance Services. Our bank’s deposits are insured to the maximum extent permitted by law by the Federal Deposit Insurance Corporation (“FDIC”). Our bank’s primary service area is the Kent and Ottawa County areas of West Michigan, which includes the City of Grand Rapids, the second largest city in the State of Michigan. In addition, our bank opened new offices in the cities of East Lansing and Ann Arbor, Michigan, during 2005. Our bank, through its eight offices, provides commercial and retail banking services primarily to small- to medium-sized businesses based in and around the Grand Rapids, Holland, Lansing and Ann Arbor metropolitan areas. These offices consist of a main office located at 310 Leonard Street NW, Grand Rapids, Michigan, a combination branch and retail loan center located at 4613 Alpine Avenue NW, Comstock Park, Michigan, a combination branch and operations center located at 5610 Byron Center Avenue SW, Wyoming, Michigan, and branches located at 4860 Broadmoor Avenue SE, Kentwood, Michigan, 3156 Knapp Street NE, Grand Rapids, Michigan, 880 East 16th Street, Holland, Michigan, 1651 West Lake Lansing Road, East Lansing, Michigan, and 325 Eisenhower Parkway, Ann Arbor, Michigan. 2. Our bank makes secured and unsecured commercial, construction, mortgage and consumer loans, and accepts checking, savings and time deposits. Our bank owns six automated teller machines ("ATM"), located at our branch locations in Grand Rapids and Holland, that participate in the MAC, NYCE and PLUS regional network systems, as well as other ATM networks throughout the country. Our bank also enables customers to conduct certain loan and deposit transactions by telephone and personal computer. Courier service is provided to certain commercial customers, and safe deposit facilities are available at our branch locations in Grand Rapids and Holland. Our bank does not have trust powers. In December 2001, our bank entered into a joint brokerage services and marketing agreement with Raymond James Financial Services, Inc. to make available to its customers financial planning, retail brokerage, equity research, insurance and annuities, retirement planning, trust services and estate planning. Our Mortgage Company Our mortgage company’s predecessor, Mercantile Bank Mortgage Company, commenced operations on October 24, 2000, when our bank contributed most of its residential mortgage loan portfolio and participation interests in certain commercial mortgage loans to Mercantile Bank Mortgage Company. On the same date, our bank also transferred its residential mortgage origination function to Mercantile Bank Mortgage Company. On January 1, 2004, Mercantile Bank Mortgage Company was reorganized as Mercantile Bank Mortgage Company, LLC, a limited liability company, which is 99% owned by our bank and 1% owned by our insurance company. The reorganization had no impact on the company’s financial position or results of operations. Mortgage loans originated and held by our mortgage company are serviced by our bank pursuant to a servicing agreement. Our Insurance Company Our insurance company acquired an existing shelf insurance agency effective April 15, 2002. An Agency and Institution Agreement was entered into among our insurance company, our bank and Hub International for the purpose of providing programs of mass marketed personal lines of insurance. Insurance product offerings include private passenger automobile, homeowners, personal inland marine, boat owners, recreational vehicle, dwelling fire, umbrella policies, small business and life insurance products, all of which are provided by and written through companies that have appointed Hub International as their agent. Our Real Estate Company Our real estate company was organized on July 21, 2003, principally to develop, construct and own our facility in downtown Grand Rapids that serves as our bank’s main office and Mercantile Bank Corporation’s headquarters. This facility was placed into service during the second quarter of 2005. Our real estate company is 99% owned by our bank and 1% owned by our insurance company. The Mercantile Trust In 2004, we formed the Mercantile trust, a Delaware business trust. Mercantile trust’s business and affairs are conducted by its property trustee, a Delaware trust company, and three individual administrative trustees who are employees and officers of the company. Mercantile trust was established for the purpose of issuing and selling its Series A and Series B trust preferred securities and common securities, and used the proceeds from the sales of those securities to acquire Series A and Series B Floating Rate Notes issued by the company. Substantially all of the net proceeds received by the company from the Series A transaction were used to redeem the trust preferred securities that had been issued by MBWM Capital Trust I in September 1999. We established MBWM Capital Trust I in 1999 to issue the trust preferred securities that were redeemed. Substantially all of the net proceeds received by the company from the Series B transaction were contributed to our bank as capital. The Series A and Series B Floating Rate Notes are categorized on our consolidated financial statements as subordinated debentures. Additional information regarding Mercantile trust is incorporated by reference to “Note 15 – Subordinated Debentures” and “Note 16 – Regulatory Matters” of the Notes to Consolidated Financial Statements included in this Annual Report on pages F-54 through F-56. 3. Effect of Government Monetary Policies Our earnings are affected by domestic economic conditions and the monetary and fiscal policies of the United States government, its agencies, and the Federal Reserve Board. The Federal Reserve Board’s monetary policies have had, and will likely continue to have, an important impact on the operating results of commercial banks through its power to implement national monetary policy in order to, among other things, curb inflation, maintain employment, and mitigate economic recessions. The policies of the Federal Reserve Board have a major effect upon the levels of bank loans, investments and deposits through its open market operations in United States government securities, and through its regulation of, among other things, the discount rate on borrowings of member banks and the reserve requirements against member bank deposits. Our bank maintains reserves directly with the Federal Reserve Bank of Chicago to the extent required by law. It is not possible to predict the nature and impact of future changes in monetary and fiscal policies. Regulation and Supervision As a bank holding company under the Bank Holding Company Act, we are required to file an annual report with the Federal Reserve Board and such additional information as the Federal Reserve Board may require. We are also subject to examination by the Federal Reserve Board. The Bank Holding Company Act limits the activities of bank holding companies that have not qualified as financial holding companies to banking and the management of banking organizations, and to certain non-banking activities. These non-banking activities include those activities that the Federal Reserve Board found, by order or regulation as of the day prior to enactment of the Gramm-Leach-Bliley Act, to be so closely related to banking as to be a proper incident to banking. These non-banking activities include, among other things: operating a mortgage company, finance company, or factoring company; performing certain data processing operations; providing certain investment and financial advice; acting as an insurance agent for certain types of credit-related insurance; leasing property on a full-payout, nonoperating basis; and providing discount securities brokerage services for customers. With the exception of the activities of our mortgage company discussed above, neither we nor any of our subsidiaries engages in any of the non-banking activities listed above. In March 2000, our election to become a financial holding company, as permitted by the Bank Holding Company Act, as amended by Title I of the Gramm-Leach-Bliley Act, was accepted by the Federal Reserve Board. In order to continue as a financial holding company, we and our bank must satisfy statutory requirements regarding capitalization, management, and compliance with the Community Reinvestment Act. As a financial holding company, we are permitted to engage in a broader range of activities than are permitted to bank holding companies. Those expanded activities include any activity which the Federal Reserve Board (in certain instances in consultation with the Department of the Treasury) determines, by order or regulation, to be financial in nature or incidental to such financial activity, or to be complementary to a financial activity and not to pose a substantial risk to the safety or soundness of depository institutions or the financial system generally. Such expanded activities include, among others: insuring, guaranteeing, or indemnifying against loss, harm, damage, illness, disability or death, or issuing annuities, and acting as principal, agent, or broker for such purposes; providing financial, investment, or economic advisory services, including advising a mutual fund; and underwriting, dealing in, or making a market in securities. Other than the insurance agency activities of our insurance company, neither we nor our subsidiaries presently engage in any of the expanded activities. Our bank is subject to restrictions imposed by federal law and regulation. Among other things, these restrictions apply to any extension of credit to us or to our other subsidiaries, to investments in stock or other securities that we issue, to the taking of such stock or securities as collateral for loans to any borrower, and to acquisitions of assets or services from, and sales of certain types of assets to, us or our other subsidiaries. Federal law restricts our ability to borrow from our bank by limiting the aggregate amount we may borrow and by requiring that all loans to us be secured in designated amounts by specified forms of collateral. 4. With respect to the acquisition of banking organizations, we are generally required to obtain the prior approval of the Federal Reserve Board before we can acquire all or substantially all of the assets of any bank, or acquire ownership or control of any voting shares of any bank or bank holding company, if, after the acquisition, we would own or control more than 5% of the voting shares of the bank or bank holding company. Acquisitions of banking organizations across state lines are subject to certain restrictions imposed by Federal and state laws and regulations. Employees As of December 31, 2006, we and our bank employed 256 full-time and 69 part-time persons. Management believes that relations with employees are good. Lending Policy As a routine part of our business, we make loans and leases to businesses and individuals located within our market areas. Our lending policy states that the function of the lending operation is twofold: to provide a means for the investment of funds at a profitable rate of return with an acceptable degree of risk, and to meet the credit needs of the creditworthy businesses and individuals who are our customers. We recognize that in the normal business of lending, some losses on loans and leases will be inevitable and should be considered a part of the normal cost of doing business. Our lending policy anticipates that priorities in extending loans and leases will be modified from time to time as interest rates, market conditions and competitive factors change. The policy sets forth guidelines on a nondiscriminatory basis for lending in accordance with applicable laws and regulations. The policy describes various criteria for granting loans and leases, including the ability to pay; the character of the customer; evidence of financial responsibility; purpose of the loan or lease; knowledge of collateral and its value; terms of repayment; source of repayment; payment history; and economic conditions. The lending policy further limits the amount of funds that may be loaned or leased against specified types of real estate collateral. For certain loans secured by real estate, the policy requires an appraisal of the property offered as collateral by a state certified independent appraiser. The policy also provides general guidelines for loan to value and lease to value limits for other types of collateral, such as accounts receivable and machinery and equipment. In addition, the policy provides general guidelines as to environmental analysis, loans to employees, executive officers and directors, problem loan and lease identification, maintenance of an allowance for loan and lease losses, loan and lease review and grading, mortgage and consumer lending, and other matters relating to our lending practices. The Board of Directors has delegated significant lending authority to officers of our bank. The Board of Directors believes this empowerment, supported by our strong credit culture and the significant experience of our commercial lending staff, makes us responsive to our customers. The loan policy currently specifies lending authority for certain officers up to $3.0 million, and $10.0 million for our bank’s Chairman of the Board and its President and Chief Executive Officer; however, the $10.0 million lending authority is generally used only in rare circumstances where timing is of the essence. Generally, loan requests exceeding $2.5 million require approval by the Officers Loan Committee, and loan requests exceeding $4.0 million, up to the legal lending limit of approximately $33.6 million, require approval by the Board of Directors. In most circumstances, we apply an in-house lending limit that is significantly less than our bank’s legal lending limit. Lending Activity Commercial Loans. Our commercial lending group originates commercial loans and leases primarily in our market areas. Our commercial lenders have extensive commercial lending experience, with most having at least ten years’ experience. Loans and leases are originated for general business purposes, including working capital, accounts receivable financing, machinery and equipment acquisition, and commercial real estate financing, including new construction and land development. 5. Working capital loans are often structured as a line of credit and are reviewed periodically in connection with the borrower’s year-end financial reporting. These loans are generally secured by substantially all of the assets of the borrower, and have an interest rate tied to the national prime rate. Loans and leases for machinery and equipment purposes typically have a maturity of three to five years and are fully amortizing, while commercial real estate loans are usually written with a five-year maturity and amortize over a 15 year period. Commercial loans and leases typically have an interest rate that is fixed to maturity or is tied to the national prime rate. We evaluate many aspects of a commercial loan or lease transaction in order to minimize credit and interest rate risk. Underwriting includes an assessment of the management, products, markets, cash flow, capital, income and collateral. This analysis includes a review of the borrower’s historical and projected financial results. Appraisals are generally required by certified independent appraisers where real estate is the primary collateral, and in some cases, where equipment is the primary collateral. In certain situations, for creditworthy customers, we may accept title reports instead of requiring lenders’ policies of title insurance. Commercial real estate lending involves more risk than residential lending because loan balances are greater and repayment is dependent upon the borrower’s business operations. We attempt to minimize the risks associated with these transactions by generally limiting our commercial real estate lending to owner-operated properties of well-known customers or new customers whose businesses have an established profitable history. In many cases, risk is further reduced by limiting the amount of credit to any one borrower to an amount considerably less than our legal lending limit and avoiding certain types of commercial real estate financings. We have no material foreign loans, and no material loans to energy producing customers. We have only limited exposure to companies engaged in agricultural-related activities. Single-Family Residential Real Estate Loans. Our mortgage company originates single-family residential real estate loans in our market area, usually according to secondary market underwriting standards. Loans not conforming to those standards are made in limited circumstances. Single-family residential real estate loans provide borrowers with a fixed or adjustable interest rate with terms up to 30 years. Our bank has a home equity line of credit program. Home equity credit is generally secured by either a first or second mortgage on the borrower’s primary residence. The program provides revolving credit at a rate tied to the national prime rate. Consumer Loans. We originate consumer loans for a variety of personal financial needs, including new and used automobiles, boat loans, credit cards and overdraft protection for our checking account customers. Consumer loans generally have shorter terms and higher interest rates and usually involve more credit risk than single-family residential real estate loans because of the type and nature of the collateral. We believe our consumer loans are underwritten carefully, with a strong emphasis on the amount of the down payment, credit quality, employment stability and monthly income of the borrower. These loans are generally repaid on a monthly repayment schedule with the source of repayment tied to the borrower’s periodic income. In addition, consumer lending collections are dependent on the borrower’s continuing financial stability, and are thus likely to be adversely affected by job loss, illness and personal bankruptcy. In many cases, repossessed collateral for a defaulted consumer loan will not provide an adequate source of repayment of the outstanding loan balance because of depreciation of the underlying collateral. We believe that the generally higher yields earned on consumer loans compensate for the increased credit risk associated with such loans, and that consumer loans are important to our efforts to serve the credit needs of the communities and customers that we serve. 6. Loan and Lease Portfolio Quality We utilize a comprehensive grading system for our commercial loans and leases as well as residential mortgage and consumer loans. All commercial loans and leases are graded on a ten grade rating system. The rating system utilizes standardized grade paradigms that analyze several critical factors such as cash flow, management and collateral coverage. All commercial loans and leases are graded at inception and reviewed at various intervals thereafter. Residential mortgage and consumer loans are graded on a four grade rating system using a separate standardized grade paradigm that analyzes several critical factors such as debt-to-income and credit and employment histories. Residential mortgage and consumer loans are graded on a random sampling basis after the loan has been made. Our independent loan and lease review program is primarily responsible for the administration of the grading system and ensuring adherence to established lending policies and procedures. The loan and lease review program is an integral part of maintaining our strong asset quality culture. The loan and lease review function works closely with senior management, although it functionally reports to the Board of Directors. All commercial loan and lease relationships equal to or exceeding $1.8 million are formally reviewed every twelve months, with a random sampling performed on credits under $1.8 million. Our watch list credits are reviewed monthly by our Watch List Committee, which is comprised of personnel from the administration, lending and loan and lease review functions. Loans and leases are placed in a nonaccrual status when, in our opinion, uncertainty exists as to the ultimate collection of principal and interest. As of December 31, 2006, loans and leases placed in nonaccrual status totaled $7.8 million, or 0.44% of total loans and leases. As of the same date, loans and leases past due 90 days or more and still accruing interest totaled $0.8 million, or 0.05% of total loans and leases. As of December 31, 2006, there were no other significant loans and leases where known information about credit problems of borrowers warranted the placing of the loans or leases in a nonaccrual status. We are not aware of any potential problem credits that could have a material adverse effect on our operating results, liquidity, or capital resources. Additional detail and information relative to the loan and lease portfolio is incorporated by reference to Management’s Discussion and Analysis of Financial Condition and Results of Operation (“Management’s Discussion and Analysis”) beginning on Page F-4 and Note 3 of the Consolidated Financial Statements on pages F-43 and F-44 included in this Annual Report. Allowance for Loan and Lease Losses In each accounting period, we adjust the allowance for loan and lease losses (“allowance”) to the amount we believe is necessary to maintain the allowance at adequate levels. Through the loan and lease review and credit departments, we attempt to allocate specific portions of the allowance based on specifically identifiable problem loans and leases. The evaluation of the allowance is further based on, but not limited to, consideration of the internally prepared Loan Loss Reserve Analysis (“Reserve Analysis”), composition of the loan and lease portfolio, third party analysis of the loan and lease administration processes and portfolio and general economic conditions. In addition, the strong commercial loan and leases growth is taken into account. 7. The Reserve Analysis, used since our inception and completed monthly, applies reserve allocation factors to outstanding loan and lease balances to calculate an overall allowance dollar amount. For commercial loans and leases, which continue to comprise a vast majority of our total loans and leases, reserve allocation factors are based upon the loan ratings as determined by our standardized grade paradigms. For retail loans, reserve allocation factors are based upon the type of credit. Adjustments for specific lending relationships, including impaired loans and leases, are made on a case-by-case basis. The reserve allocation factors are primarily based on the recent levels and historical trends of net loan charge-offs and non-performing assets, the comparison of the recent levels and historical trends of net loan charge-offs and non-performing assets with a customized peer group consisting of ten similarly-sized publicly traded banking organizations conducting business in the states of Michigan, Illinois, Indiana and/or Ohio, the review and consideration of our loan migration analysis and the experience of senior management making similar loans and leases for an extensive period of time. We regularly review the Reserve Analysis and make adjustments periodically based upon identifiable trends and experience. We believe that the present allowance is adequate, based on the broad range of considerations listed above. The primary risks associated with commercial loans and leases are the financial condition of the borrower, the sufficiency of collateral, and lack of timely payment. We have a policy of requesting and reviewing periodic financial statements from its commercial loan and lease customers, and periodically reviewing existence of collateral and its value. The primary risk element that we consider for consumer and residential real estate loan is lack of timely payment. We have a reporting system that monitors past due loans and have adopted policies to pursue our creditor’s rights in order to preserve our bank’s collateral position. Additional detail regarding the allowance is incorporated by reference to Management’s Discussion and Analysis beginning on Page F-4 and Note 3 of the Notes to Consolidated Financial Statements of the Company on pages F-43 and F-44 included in this Annual Report. Although we believe the allowance is adequate to absorb probable incurred losses as they arise, there can be no assurance that we will not sustain losses in any given period which could be substantial in relation to, or greater than, the size of the allowance. Investments Bank Holding Company Investments. The principal investments of our bank holding company are the investments in the common stock of our bank and the common securities of Mercantile trust. Other funds of our bank holding company may be invested from time to time in various debt instruments. As a bank holding company, we are also permitted to make portfolio investments in equity securities and to make equity investments in subsidiaries engaged in a variety of non-banking activities, which include real estate-related activities such as community development, real estate appraisals, arranging equity financing for commercial real estate, and owning and operating real estate used substantially by our bank or acquired for its future use. In addition, our bank holding company’s qualification as a financial holding company enables us to make equity investments in companies engaged in a broader range of financial activities than we could do without that qualification. Such expanded activities include insuring, guaranteeing, or indemnifying against loss, harm, damage, illness, disability or death, or issuing annuities, and acting as principal, agent, or broker for such purposes; providing financial, investment, or economic advisory services, including advising a mutual fund; and underwriting, dealing in, or making a market in securities. Our bank holding company has no plans at this time to make directly any of these equity investments at the bank holding company level. Our Board of Directors may, however, alter the investment policy at any time without shareholder approval. 8. In addition, so long as our bank holding company is qualified as a financial holding company, it would be permitted, as part of the business of underwriting or merchant banking activity and under certain circumstances and procedures, to invest in shares or other ownership interests in, or assets of, companies engaged in non-financial activities. In order to make those investments, our bank holding company would be required (i) to become, or to have an affiliate that is, a registered securities broker or dealer or a registered municipal securities dealer, or (ii) to control both an insurance company predominantly engaged in underwriting life, accident and health, or property and casualty insurance (other than credit insurance) or issuing annuities, and a registered investment adviser that furnishes investment advice to an insurance company. We do not currently have any securities, insurance, or investment advisory affiliates of the required types, nor does our bank holding company have any current plans to make any of the equity investments described in this paragraph. Our Bank’s Investments. Our bank may invest its funds in a wide variety of debt instruments and may participate in the federal funds market with other depository institutions. Subject to certain exceptions, our bank is prohibited from investing in equity securities. Among the equity investments permitted for our bank under various conditions and subject in some instances to amount limitations, are shares of a subsidiary insurance agency, mortgage company, real estate company, or Michigan business and industrial development company, such as our insurance company, our mortgage company, or our real estate company. Under another such exception, in certain circumstances and with prior notice to or approval of the FDIC, our bank could invest up to 10% of its total assets in the equity securities of a subsidiary corporation engaged in the acquisition and development of real property for sale, or the improvement of real property by construction or rehabilitation of residential or commercial units for sale or lease. Our bank has no present plans to make such an investment. Real estate acquired by our bank in satisfaction of or foreclosure upon loans may be held by our bank for specified periods. Our bank is also permitted to invest in such real estate as is necessary for the convenient transaction of its business. Our bank’s Board of Directors may alter the bank’s investment policy without shareholder approval at any time. Additional detail and information relative to the securities portfolio is incorporated by reference to Management’s Discussion and Analysis beginning on Page F-4 and Note 2 of the Notes to Consolidated Financial Statements on pages F-40 through F-42 included in this Annual Report. Competition Our primary markets for loans and core deposits are the Grand Rapids, Holland, Lansing and Ann Arbor metropolitan areas. We face substantial competition in all phases of our operations from a variety of different competitors. We compete for deposits, loans and other financial services with numerous Michigan- based and out-of-state banks, savings banks, thrifts, credit unions and other financial institutions as well as from other entities that provide financial services. Some of the financial institutions and financial service organizations with which we compete are not subject to the same degree of regulation as we are. Many of our primary competitors have been in business for many years, have established customer bases, are larger, have substantially higher lending limits than we do, and offer larger branch networks and other services which we do not. Most of these same entities have greater capital resources than we do, which, among other things, may allow them to price their services at levels more favorable to the customer and to provide larger credit facilities than we do. Under the Gramm-Leach-Bliley Act, effective March 11, 2000, securities firms and insurance companies that elect to become financial holding companies may acquire banks and other financial institutions. The Gramm-Leach-Bliley Act may significantly change the competitive environment in which we conduct our business. The financial services industry is also likely to become more competitive as further technological advances enable more companies to provide financial services. Selected Statistical Information Management’s Discussion and Analysis beginning on Page F-4 in this Annual Report includes selected statistical information. 9. Return on Equity and Assets Return on Equity and Asset information is included in Management’s Discussion and Analysis beginning on Page F-4 in this Annual Report. Available Information We maintain an internet website at www.mercbank.com. We make available on or through our website, free of charge, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practical after we electronically file such material with, or furnish it to, the Securities and Exchange Commission. We do not intend the address of our website to be an active link or to otherwise incorporate the contents of our website into this Annual Report. ITEM 1A. RISK FACTORS The following risk factors could affect our business, financial condition or results of operations. These risk factors should be considered in connection with evaluating the forward-looking statements contained in this Annual Report because they could cause the actual results and conditions to differ materially from those projected in forward-looking statements. Before you buy our common stock, you should know that investing in our common stock involves risks, including the risks described below. The risks that are highlighted here are not the only ones we face. If the adverse matters referred to in any of the risks actually occur, our business, financial condition or operations could be adversely affected. In that case, the trading price of our common stock could decline, and you may lose all or part of your investment. Adverse changes in economic conditions or interest rates may negatively affect our earnings, capital and liquidity. The results of operations for financial institutions, including our bank, may be materially and adversely affected by changes in prevailing local and national economic conditions, including declines in real estate market values and the related declines in value of our real estate collateral, rapid increases or decreases in interest rates and changes in the monetary and fiscal policies of the federal government. Our profitability is heavily influenced by the spread between the interest rates we earn on loans and investments and the interest rates we pay on deposits and other interest-bearing liabilities. Substantially all of our loans are to businesses and individuals in western, south central, or southeastern Michigan, and any decline in the economy of these areas could adversely affect us. Like most banking institutions, our net interest spread and margin will be affected by general economic conditions and other factors that influence market interest rates and our ability to respond to changes in these rates. At any given time, our assets and liabilities may be such that they will be affected differently by a given change in interest rates. Our credit losses could increase and our allowance for loan and lease losses may not be adequate to cover actual loan losses. The risk of nonpayment of loans is inherent in all lending activities, and nonpayment, when it occurs, may have a materially adverse effect on our earnings and overall financial condition as well as the value of our common stock. Our focus on commercial lending may result in a larger concentration of loans to small businesses. As a result, we may assume different or greater lending risks than other banks. We make various assumptions and judgments about the collectibility of our loan portfolio and provide an allowance for losses based on several factors. If our assumptions are wrong, our allowance for loan and lease losses may not be sufficient to cover our losses, which would have an adverse effect on our operating results. While we have not experienced unusual amounts of charge-offs or nonperforming loans, we cannot assure you that we will not experience an increase in delinquencies and losses as the loans and leases continue to mature. The actual amounts of future provisions for loan and lease losses cannot be determined at this time and may exceed the amounts of past provisions. Additions to our allowance for loan and lease losses decrease our net income. 10. We rely heavily on our management and other key personnel, and the loss of any of them may adversely affect our operations. We are and will continue to be dependent upon the services of our management team, including Gerald R. Johnson, Jr., our Chairman and Chief Executive Officer, Michael H. Price, our President and Chief Operating Officer, and our other senior managers. The loss of either Mr. Johnson or Mr. Price, or any of our other senior managers, could have an adverse effect on our growth and performance. We have entered into employment contracts with Mr. Johnson and Mr. Price and two other executive officers. The contracts provide for a three year employment period that is extended for an additional year each year unless a notice is given indicating that the contract will not be extended. In addition, we continue to depend on our city presidents and key commercial loan officers. Our city presidents and several of our commercial loan officers are responsible, or share responsibility, for generating and managing a significant portion of our commercial loan and lease portfolio. Our success can be attributed in large part to the relationships these officers as well as members of our management team have developed and are able to maintain with our customers as we continue to implement our community banking philosophy. The loss of any of these commercial loan officers could adversely affect our loan and lease portfolio and performance, and our ability to generate new loans and leases. Many of our key employees have signed agreements with us agreeing not to compete with us in one or more of our markets for specified time periods if they leave employment with us. Some of the other financial institutions in our markets also require their key employees to sign agreements that preclude or limit their ability to leave their employment and compete with them or solicit their customers. These agreements make it more difficult for us to hire loan officers with experience in our markets who can immediately solicit their former or new customers on our behalf. Decline in the availability of out-of-area deposits could cause liquidity or interest rate margin concerns, or limit our growth. We have utilized and expect to continue to utilize out-of-area or wholesale deposits to support our asset growth. These deposits are generally a lower cost source of funds when compared to the interest rates that we would have to offer in our local markets to generate a commensurate level of funds. In addition, the overhead costs associated with wholesale deposits are considerably less than the overhead costs we would incur to obtain and administer a similar level of local deposits. A decline in the availability of these wholesale deposits would require us to fund our growth with more costly funding sources, which could reduce our net interest margin, limit our growth, reduce our asset size, or increase our overhead costs. Future sales of our common stock or other securities may dilute the value of our common stock. In many situations, our Board of Directors has the authority, without any vote of our shareholders, to issue shares of our authorized but unissued stock, including shares authorized and unissued under our Stock Incentive Plan of 2006. In the future, we may issue additional securities, through public or private offerings, in order to raise additional capital. Any such issuance would dilute the percentage of ownership interest of existing shareholders and may dilute the per share book value of the common stock. In addition, option holders under our stock-based incentive plans may exercise their options at a time when we would otherwise be able to obtain additional equity capital on more favorable terms. 11. Our growth and expansion may be limited by many factors. Our primary growth strategy has been to grow internally by increasing our business in the western Michigan area, and more recently in the Lansing and Ann Arbor areas of Michigan. We are also considering other areas in which we may expand our business. This internal growth strategy depends in large part on generating an increasing level of loans and deposits at acceptable risk and interest rate levels without commensurate increases in non-interest expenses. There can be no assurance that we will be successful in continuing our growth strategy due to delays and other impediments resulting from regulatory oversight, limited availability of qualified personnel and favorable and cost effective branch sites, and management time, capital, and expenses required to develop new branch sites and markets. In addition, the success of our growth strategy will depend on maintaining sufficient regulatory capital levels and on adequate economic conditions in our market areas. In addition, although we have no current plans to do so, we may acquire banks, related businesses or branches of other financial institutions that we believe provide a strategic fit with our business. To the extent that we grow through acquisitions, we cannot assure you that we will be able to adequately or profitably manage this growth. Acquiring other banks, businesses, or branches involves risks commonly associated with acquisitions, including exposure to unknown or contingent liabilities and asset quality issues, difficulty and expense of integrating the operations and personnel, potential disruption to our business including the diversion of management’s time and attention, and the possible loss of key employees and customers. Our future success is dependent on our ability to compete effectively in the highly competitive banking industry. We face substantial competition in all phases of our operations from a variety of different competitors. Our future growth and success will depend on our ability to compete effectively in this highly competitive environment. We compete for deposits, loans and other financial services with numerous Michigan-based and out-of-state banks, thrifts, credit unions and other financial institutions as well as other entities that provide financial services, including securities firms and mutual funds. Some of the financial institutions and financial service organizations with which we compete are not subject to the same degree of regulation as we are. Most of our competitors have been in business for many years, have established customer bases, are larger, have substantially higher lending limits than we do and offer branch networks and other services which we do not, including trust and international banking services. Most of these entities have greater capital and other resources than we do, which, among other things, may allow them to price their services at levels more favorable to the customer and to provide larger credit facilities than we do. This competition may limit our growth or earnings. Under the Gramm-Leach-Bliley Act of 1999, effective March 11, 2000, securities firms and insurance companies that elect to become financial holding companies may acquire banks and other financial institutions. The Gramm-Leach-Bliley Act affects the competitive environment in which we conduct business. The financial services industry is also likely to become more competitive as further technological advances enable more companies to provide financial services. These technological advances may diminish the importance of depository institutions and other financial intermediaries in the transfer of funds between parties. We are subject to significant government regulation, and any regulatory changes may adversely affect us. The banking industry is heavily regulated under both federal and state law. These regulations are primarily intended to protect customers, not our creditors or shareholders. Existing state and federal banking laws subject us to substantial limitations with respect to the making of loans, the purchase of securities, the payment of dividends and many other aspects of our business. Some of these laws may benefit us, others may increase our costs of doing business, or otherwise adversely affect us and create competitive advantages for others. Regulations affecting banks and financial services companies undergo continuous change, and we cannot predict the ultimate effect of these changes, which could have a material adverse effect on our profitability or financial condition. Federal economic and monetary policy may also affect our ability to attract deposits, make loans and achieve satisfactory interest spreads. 12. We continually encounter technological change, and we may have fewer resources than our competitors to continue to invest in technological improvements. The banking industry is undergoing technological changes with frequent introductions of new technology-driven products and services. In addition to better serving customers, the effective use of technology increases efficiency and enables financial institutions to reduce costs. Our future success will depend, in part, on our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands for convenience as well as create additional efficiencies in our operations. Many of our competitors have substantially greater resources to invest in technological improvements. There can be no assurance that we will be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our customers. Our Articles of Incorporation and By-laws and the laws of Michigan contain provisions that may discourage or prevent a takeover of our company and reduce any takeover premium. Our Articles of Incorporation and By-laws, and the corporate laws of the State of Michigan, include provisions which are designed to provide our Board of Directors with time to consider whether a hostile takeover offer is in our and our shareholders’ best interest. These provisions, however, could discourage potential acquisition proposals and could delay or prevent a change in control. The provisions also could diminish the opportunities for a holder of our common stock to participate in tender offers, including tender offers at a price above the then-current market price for our common stock. These provisions could also prevent transactions in which our shareholders might otherwise receive a premium for their shares over then- current market prices, and may limit the ability of our shareholders to approve transactions that they may deem to be in their best interests. The Michigan Business Corporation Act contains provisions intended to protect shareholders and prohibit or discourage various types of hostile takeover activities. In addition to these provisions and the provisions of our Articles of Incorporation and Bylaws, federal law requires the Federal Reserve Board’s approval prior to acquiring “control” of a bank holding company. All of these provisions may delay or prevent a change in control without action by our shareholders and could adversely affect the price of our common stock. There is a limited trading market for our common stock. The price of our common stock has been, and will likely continue to be, subject to fluctuations based on, among other things, economic and market conditions for bank holding companies and the stock market in general, as well as changes in investor perceptions of our company. The issuance of new shares of our common stock also may affect the market for our common stock. Our common stock is traded on the Nasdaq Global Select Market under the symbol “MBWM”. The development and maintenance of an active public trading market depends upon the existence of willing buyers and sellers, the presence of which is beyond our control. While we are a publicly-traded company, the volume of trading activity in our stock is still relatively limited. Even if a more active market develops, there can be no assurance that such a market will continue, or that our shareholders will be able to sell their shares at or above the offering price. We have paid a 5% stock dividend on our common stock each year since 2001, and have paid a quarterly cash dividend each quarter beginning with the first quarter of 2003. While we expect to continue paying cash dividends, there is no assurance that we will continue to do so. 13. Our business is subject to operational risks. We, like most financial institutions, are exposed to many types of operational risks, including the risk of fraud by employees or outsiders, unauthorized transactions by employees or operational errors. Operational errors may include clerical or record keeping errors or those resulting from faulty or disabled computer or telecommunications systems. Given our volume of transactions, certain errors may be repeated or compounded before they are discovered and successfully corrected. Our necessary dependence upon automated systems to record and process our transaction volume may further increase the risk that technical system flaws or employee tampering or manipulation of those systems will result in losses that are difficult to detect. We may also be subject to disruptions of our operating systems arising from events that are wholly or partially beyond our control, including, for example, computer viruses or electrical or telecommunications outages, which may give rise to losses in service to customers and to loss or liability to us. We are further exposed to the risk that our external vendors may be unable to fulfill their contractual obligations to us, or will be subject to the same risk of fraud or operational errors by their respective employees as are we, and to the risk that our or our vendors’ business continuity and data security systems prove not to be sufficiently adequate. We also face the risk that the design of our controls and procedures prove inadequate or are circumvented, causing delays in detection or errors in information. Although we maintain a system of controls designed to keep operational risk at appropriate levels, there can be no assurance that we will not suffer losses from operational risks in the future that may be material in amount. ITEM IB. UNRESOLVED STAFF COMMENTS We have received no written comments regarding our periodic or current reports from the staff of the Securities and Exchange Commission that were issued 180 days or more before the end of our 2006 fiscal year and that remain unresolved. ITEM 2. PROPERTIES During 2005, our bank placed into service a new four-story facility located approximately two miles north from the center of downtown Grand Rapids. Design and construction of this facility had started during 2003. This new facility serves as the Company’s headquarters and our bank’s main office, and houses the administration function, our bank’s commercial lending and review function, our bank’s loan operations function, a full service branch, portions of our bank’s retail lending and business development function and our bank’s retail brokerage operation. A majority of functions housed at this facility were formerly operated out of a leased facility located at 216 North Division Avenue, Grand Rapids, Michigan, approximately two miles from the new facility. The new facility consists of approximately 55,000 square feet of usable space and contains multiple drive-through lanes with ample parking. The land and building are owned by our real estate company. The address of this facility is 310 Leonard Street NW, Grand Rapids, Michigan. Our bank designed and constructed a full service branch and retail loan facility which opened in July of 1999 in Alpine Township, a northwest suburb of Grand Rapids. The facility is one story and has approximately 8,000 square feet of usable space. The land and building are owned by our bank. The facility has multiple drive-through lanes and ample parking space. The address of this facility is 4613 Alpine Avenue NW, Comstock Park, Michigan. 14. During 2001, our bank designed and constructed two facilities on a 4-acre parcel of land located in the City of Wyoming, a southwest suburb of Grand Rapids. The land had been purchased by our bank in 2000. The larger of the two buildings is a full service branch and deposit operations facility which opened in September of 2001. The facility is two-stories and has approximately 25,000 square feet of usable space. The facility is owned by our bank and has multiple drive-through lanes and ample parking space. The address of this facility is 5610 Byron Center Avenue SW, Wyoming, Michigan. The other building is a single-story facility with approximately 11,000 square feet of usable space. Our bank’s accounting, audit, loss prevention and wire transfer functions are housed in this building, which underwent a renovation in 2005 that almost doubled its size. This facility is also owned by our bank. The address of this facility is 5650 Byron Center Avenue SW, Wyoming, Michigan. During 2002, our bank designed and constructed a full service branch which opened in December of 2002 in the City of Kentwood, a southeast suburb of Grand Rapids. The land had been purchased by our bank in 2001. The facility is one story and has approximately 10,000 square feet of usable space. The facility is owned by our bank and has multiple drive-through lanes and ample parking space. The address of this facility is 4860 Broadmoor Avenue SW, Kentwood, Michigan. During 2003, our bank designed and constructed a full service branch in the northeast quadrant of the City of Grand Rapids. The land had been purchased by our bank in 2002. The facility is one story and has approximately 3,500 square feet of usable space. The facility is owned by our bank and has multiple drive- through lanes and ample parking space. The address of this facility is 3156 Knapp Street NE, Grand Rapids, Michigan. During 2003, our bank designed and started construction of a new two-story facility located in Holland, Michigan. This facility, which was completed during the fourth quarter of 2004, serves as a full service banking center for the Holland area, including commercial lending, retail lending and a full service branch. The facility consists of approximately 30,000 square feet of usable space and contains multiple drive- through lanes with ample parking. The address of this facility is 880 East 16th Street, Holland, Michigan. During 2005, our bank opened a branch facility in the City of East Lansing, Michigan. The facility is one story and has approximately 7,500 square feet of usable space. The facility is operated under a lease agreement between our bank and a third party. There is ample parking space, but no drive-through lanes. The address of this facility is 1651 West Lake Lansing Road, East Lansing, Michigan. During 2005, our bank opened a branch facility in the City of Ann Arbor, Michigan. The facility is one story and has approximately 10,000 square feet of usable space. The facility is operated under a lease agreement between our bank and a third party. There is ample parking space, but no drive-through lanes. The address of this facility is 325 Eisenhower Parkway, Ann Arbor, Michigan. During 2006, our bank purchased approximately 3 acres of vacant land and designed and initiated construction of a new three-story facility in East Lansing, Michigan. This facility, which is expected to be completed during the second quarter of 2007, will serve as a full service banking center for the greater Lansing area, including commercial lending, retail lending, and a full service branch. The facility will consist of approximately 27,000 square feet of usable space and will contain multiple drive-through lanes with ample parking. When completed, this facility will replace the leased facility noted above located on West Lake Lansing Road in East Lansing. The address of this facility is 3737 Coolidge Road, East Lansing, Michigan. ITEM 3. LEGAL PROCEEDINGS From time to time, we may be involved in various legal proceedings that are incidental to our business. In the opinion of management, we are not a party to any legal proceedings that are material to our financial condition, either individually or in the aggregate. 15. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None PART II ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES Our common stock is listed on the Nasdaq Global Select Market under the symbol “MBWM”. At February 12, 2007, there were 305 record holders of our common stock. In addition, we estimate that there were approximately 4,000 beneficial owners of our common stock who own their shares through brokers or banks. The following table shows the high and low sales prices for our common stock as reported by the Nasdaq Global Select Market for the periods indicated and the quarterly cash dividends paid by us during those periods. The prices have been adjusted for the 5% stock dividends paid on May 16, 2006 and August 1, 2005. High Low Dividend 2006 First Quarter............................................. Second Quarter ........................................ 40.55 35.30 Third Quarter ........................................... 41.05 36.92 Fourth Quarter ......................................... 40.81 37.06 $ 38.20 $ 35.71 $ 0.12 0.13 0.13 0.13 2005 First Quarter............................................. Second Quarter ........................................ 41.67 35.56 Third Quarter ........................................... 45.95 39.68 Fourth Quarter ......................................... 40.92 35.67 $ 34.65 $ 41.52 $ 0.10 0.11 0.11 0.11 Holders of our common stock are entitled to receive dividends that the Board of Directors may declare from time to time. We may only pay dividends out of funds that are legally available for that purpose. We are a holding company and substantially all of our assets are held by our subsidiaries. Our ability to pay dividends to our shareholders depends primarily on our bank’s ability to pay dividends to us. Dividend payments and extensions of credit to us from our bank are subject to legal and regulatory limitations, generally based on capital levels and current and retained earnings, imposed by law and regulatory agencies with authority over our bank. The ability of our bank to pay dividends is also subject to its profitability, financial condition, capital expenditures and other cash flow requirements. In addition, under the terms of our subordinated debentures, we would be precluded from paying dividends on our common stock if an event of default has occurred and is continuing under the subordinated debentures, or if we exercised our right to defer payments of interest on the subordinated debentures, until the deferral ended. On January 9, 2007, we declared a $0.14 per share cash dividend on our common stock, payable on March 9, 2007 to record holders as of February 9, 2007. We currently expect to continue to pay a quarterly cash dividend, although there can be no assurance that we will continue to do so. 16. Issuer Purchases of Equity Securities (a) Total Number of Shares Purchased 0 421 0 421 (b) Average Price Paid Per Share $ N/A 38.35 N/A $ 38.35 (c) Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs 0 0 0 0 (d) Maximum Number of Shares that May Yet Be Purchased Under the Plans or Programs 0 0 0 0 Period October 1 – 31 November 1 – 30 December 1 – 31 Total The shares shown in column (a) above as having been purchased were acquired from one of our employees when she used shares of common stock that she already owned to pay part of the exercise price when exercising stock options issued under one of our employee stock option plans. Shareholder Return Performance Graph Set forth below is a line graph comparing the yearly percentage change in the cumulative total shareholder return on our common stock (based on the last reported sales price of the respective year) with the cumulative total return of the Nasdaq Composite Index and the SNL Nasdaq Bank Index from December 31, 2001 through December 31, 2006. The following is based on an investment of $100 on December 31, 2001 in our common stock, the Nasdaq Composite Index and the SNL Nasdaq Bank Index, with dividends reinvested where applicable. 17. Index Mercantile Bank Corporation NASDAQ Composite SNL NASDAQ Bank Index 12/31/01 100.00 100.00 100.00 12/31/02 139.90 68.76 102.85 12/31/03 229.27 103.67 132.76 12/31/04 263.15 113.16 152.16 12/30/05 272.06 115.57 147.52 12/31/06 283.42 127.58 165.62 Period Ending ITEM 6. SELECTED FINANCIAL DATA The Selected Financial Data on page F-3 in this Annual Report is incorporated here by reference. ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION Management’s Discussion and Analysis on pages F-4 through F-22 in this Annual Report is incorporated here by reference. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The information under the heading “Market Risk Analysis” on pages F-22 through F-25 in this Annual Report is incorporated here by reference. 18. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Consolidated Financial Statements, Notes to Consolidated Financial Statements and the Reports of Independent Registered Public Accounting Firm on pages F-26 through F-59 in this Annual Report are incorporated here by reference. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE On September 14, 2006, our Audit Committee concluded its proposal process for selection of an independent registered public accounting firm for 2007, and appointed BDO Seidman, LLP as our independent registered public accounting firm for the calendar year ending December 31, 2007. On the same date, our Audit Committee determined to dismiss Crowe Chizek and Company LLC as our independent registered public accounting firm after it completed its work for the calendar year ending December 31, 2006, and advised Crowe Chizek and Company LLC that it would not be engaged as our independent registered public accounting firm for the calendar year ending December 31, 2007. We filed a report on Form 8-K with the Securities and Exchange Commission on September 19, 2006 reporting the change of accountants and making related disclosures. ITEM 9A. CONTROLS AND PROCEDURES As of December 31, 2006, an evaluation was performed under the supervision of and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on that evaluation, our management, including our Chief Executive Officer and Chief Financial Officer, concluded that our disclosure controls and procedures were effective as of December 31, 2006. There have been no significant changes in our internal controls over financial reporting during the quarter ended December 31, 2006, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f). Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the framework in Internal Control – Integrated Framework, our management concluded that our internal control over financial reporting was effective as of December 31, 2006. Our management’s assessment of the effectiveness of our internal control over financial reporting as of December 31, 2006 has been audited by Crowe Chizek and Company LLC, an independent registered public accounting firm, as stated in their report which is included in this Annual Report. ITEM 9B. OTHER INFORMATION None 19. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information presented under the captions “Election of Directors,” “Executive Officers,” “Section 16(a) Beneficial Ownership Compliance” and “Corporate Governance – Code of Ethics” in the definitive Proxy Statement of Mercantile for our April 26, 2007 Annual Meeting of Shareholders (the “Proxy Statement”), a copy of which will be filed with the Securities and Exchange Commission before the meeting date, is incorporated here by reference. We have a separately-designated standing audit committee established in accordance with Section 3(a)(58)(A) of the Securities Exchange Act of 1934. The members of the Audit Committee consist of Betty S. Burton, David M. Cassard, C. John Gill, David M. Hecht, Calvin D. Murdock and Merle J. Prins. The Board of Directors has determined that Mr. Cassard, a member of the Audit Committee, is qualified as an audit committee financial expert, as that term is defined in the rules of the Securities and Exchange Commission. Mr. Cassard is independent, as independence for audit committee members is defined in the Nasdaq listing standards and the rules of the Securities and Exchange Commission. ITEM 11. EXECUTIVE COMPENSATION The information presented under the captions “Executive Compensation,” “Corporate Governance – Compensation Committee Interlocks and Insider Participation” and “Compensation Committee Report” in the Proxy Statement is incorporated here by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The information presented under the caption “Stock Ownership of Certain Beneficial Owners and Management” in the Proxy Statement is incorporated here by reference. Equity Compensation Plan Information The following table summarizes information, as of December 31, 2006, relating to compensation plans under which equity securities are authorized for issuance. Number of securities to be issued upon exercise of outstanding options, warrants and rights (a) Weighted average exercise price of outstanding options, warrants and rights (b) Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a)) (c) 275,369 $ 25.28 550,884 (2) 0 0 0 Plan Category Equity compensation plans approved by security holders (1) Equity compensation plans not approved by security holders Total 275,369 $ 25.28 550,884 20. (1) These plans are Mercantile’s 1997 Employee Stock Option Plan, 2000 Employee Stock Option Plan, 2004 Employee Stock Option Plan, Independent Director Stock Option Plan and the Stock Incentive Plan of 2006. (2) These securities are available under the Stock Incentive Plan of 2006. Incentive awards may include, but are not limited to, stock options, restricted stock, stock appreciation rights and stock awards. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information presented under the captions “Transactions with Related Persons” and “Corporate Governance – Director Independence” in the Proxy Statement is incorporated here by reference. ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES The information presented under the caption “Principal Accountant Fees and Services” in the Proxy Statement is incorporated here by reference. PART IV ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES (a) (1) Financial Statements. The following financial statements and reports of independent registered public accounting firm of Mercantile Bank Corporation and its subsidiaries are filed as part of this report: Reports of Independent Registered Public Accounting Firm dated February 20, 2007 Consolidated Balance Sheets --- December 31, 2006 and 2005 Consolidated Statements of Income for each of the three years in the period ended December 31, 2006 Consolidated Statements of Changes in Shareholders’ Equity for each of the three years in the period ended December 31, 2006 Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 2006 Notes to Consolidated Financial Statements The financial statements, the notes to financial statements, and the reports of independent registered public accounting firm listed above are incorporated by reference in Item 8 of this report. (2) Financial Statement Schedules Not applicable 21. (b) Exhibits: EXHIBIT NO. 3.1 3.2 10.1 10.2 10.3 10.4 10.5 10.6 10.7 10.8 10.9 10.10 10.11 EXHIBIT DESCRIPTION Our Articles of Incorporation are incorporated by reference to exhibit 3.1 of our Form 10-Q for the quarter ended June 30, 2004 Our Amended and Restated Bylaws dated as of January 16, 2003 are incorporated by reference to exhibit 3.2 of our Registration Statement on Form S-3 (Commission File No. 333-103376) that became effective on February 21, 2003 Our 1997 Employee Stock Option Plan is incorporated by reference to exhibit 10.1 of our Registration Statement on Form SB-2 (Commission File No. 333- 33081) that became effective on October 23, 1997 * Our 2000 Employee Stock Option Plan is incorporated by reference to exhibit 10.14 of our Form 10-K for the year ended December 31, 2000 * Our 2004 Employee Stock Option Plan is incorporated by reference to exhibit 10.1 of our Form 10-Q for the quarter ended September 30, 2004 * Form of Stock Option Agreement for options under the 2004 Employee Stock Option Plan is incorporated by reference to exhibit 10.2 of our Form 10-Q for the quarter ended September 30, 2004 * Our Independent Director Stock Option Plan is incorporated by reference to exhibit 10.26 of our Form 10-K for the year ended December 31, 2002 * Form of Stock Option Agreement for options under the Independent Director Stock Option Plan is incorporated by reference to exhibit 10.1 of our Form 8-K dated October 21, 2004 * Nonlender Bonus Plan is incorporated by reference to exhibit 10.3 of our Form 10-Q for the quarter ended September 30, 2004 * Mercantile Bank of West Michigan Deferred Compensation Plan for Members of the Board of Directors (1999) is incorporated by reference to Exhibit 10.6 of the Registration Statement of the company and our trust on Form SB-2 (Commission File Nos. 333-84313 and 333-84313-01) that became effective on September 13, 1999 * Agreement between Fiserv Solutions, Inc. and our bank dated September 10, 1997, is incorporated by reference to exhibit 10.3 of our Registration Statement on Form SB-2 (Commission File No. 333-33081) that became effective on October 23, 1997 Extension Agreement of Data Processing Contract between Fiserv Solutions, Inc. and our bank dated May 12, 2000 extending the agreement between Fiserv Solutions, Inc. and our bank dated September 10, 1997, is incorporated by reference to exhibit 10.15 of our Form 10-K for the year ended December 31, 2000 Extension Agreement of Data Processing Contract between Fiserv Solutions, Inc. and our bank dated November 22, 2002 extending the agreement between Fiserv Solutions, Inc. and our bank dated September 10, 1997, is incorporated by reference to exhibit 10.5 of our Form 10-K for the year ended December 31, 2002 22. EXHIBIT NO. 10.12 10.13 10.14 10.15 10.16 10.17 10.18 10.19 10.20 10.21 10.22 10.23 10.24 EXHIBIT DESCRIPTION Amended and Restated Employment Agreement dated as of October 18, 2001, among the company, our bank and Gerald R. Johnson, Jr., is incorporated by reference to exhibit 10.21 of our Form 10-K for the year ended December 31, 2001 * Amended and Restated Employment Agreement dated as of October 18, 2001, among the company, our bank and Michael H. Price, is incorporated by reference to exhibit 10.22 of our Form 10-K for the year ended December 31, 2001 * Employment Agreement dated as of October 18, 2001, among the company, our bank and Robert B. Kaminski, Jr., is incorporated by reference to exhibit 10.23 of our Form 10-K for the year ended December 31, 2001 * Employment Agreement dated as of October 18, 2001, among the company, our bank and Charles E. Christmas, is incorporated by reference to exhibit 10.23 of our Form 10-K for the year ended December 31, 2001 * Amendment to Employment Agreement dated as of October 17, 2002, among the company, our bank and Gerald R. Johnson, Jr., is incorporated by reference to exhibit 10.21 of our Form 10-K for the year ended December 31, 2002 * Amendment to Employment Agreement dated as of October 17, 2002, among the company, our bank and Michael H. Price, is incorporated by reference to exhibit 10.22 of our Form 10-K for the year ended December 31, 2002 * Amendment to Employment Agreement dated as of October 17, 2002, among the company, our bank and Robert B. Kaminski, Jr., is incorporated by reference to exhibit 10.23 of our Form 10-K for the year ended December 31, 2002 * Amendment to Employment Agreement dated as of October 17, 2002, among the company, our bank and Charles E. Christmas, is incorporated by reference to exhibit 10.24 of our Form 10-K for the year ended December 31, 2002 * Amendment to Employment Agreement dated as of October 28, 2004, among the company, our bank and Robert B. Kaminski, Jr., is incorporated by reference to exhibit 10.21 of our Form 10-K for the year ended December 31, 2004 * Junior Subordinated Indenture between us and Wilmington Trust Company dated September 16, 2004 providing for the issuance of the Series A and Series B Floating Rate Junior Subordinated Notes due 2034 is incorporated by reference to exhibit 10.1 of our Form 8-K dated December 15, 2004 Amended and Restated Trust Agreement dated September 16, 2004 for Mercantile Bank Capital Trust I is incorporated by reference to exhibit 10.2 of our Form 8-K dated December 15, 2004 Placement Agreement between us, Mercantile Bank Capital Trust I, and SunTrust Capital Markets, Inc. dated September 16, 2004 is incorporated by reference to exhibit 10.3 of our Form 8-K dated December 15, 2004 Guarantee Agreement dated September 16, 2004 between Mercantile as Guarantor and Wilmington Trust Company as Guarantee Trustee is incorporated by reference to exhibit 10.4 of our Form 8-K dated December 15, 2004 23. EXHIBIT NO. EXHIBIT DESCRIPTION 10.25 10.26 10.27 10.28 10.29 10.30 10.31 10.32 10.33 10.34 10.35 10.36 Non-Lender Bonus Plan 2006, is incorporated by reference to exhibit 10.1 of our Form 8-K dated November 22, 2005 * Form of Agreement Amending Stock Option Agreement, dated November 17, 2005 issued under our 2004 Employee Stock Option Plan, is incorporated by reference to exhibit 10.1 of our Form 8-K dated December 12, 2005 * Second Amendment to Employment Agreement dated as of November 17, 2005, among the company, our bank and Gerald R. Johnson, Jr. is incorporated by reference to exhibit 10.28 of our Form 10-K for the year ended December 31, 2005 * Second Amendment to Employment Agreement dated as of November 17, 2005, among the company, our bank and Michael H. Price is incorporated by reference to exhibit 10.29 of our Form 10-K for the year ended December 31, 2005 * Third Amendment to Employment Agreement dated as of November 17, 2005, among the company, our bank and Robert B. Kaminski, Jr. is incorporated by reference to exhibit 10.30 of our Form 10-K for the year ended December 31, 2005 * Second Amendment to Employment Agreement dated as of November 17, 2005, among the company, our bank and Charles E. Christmas is incorporated by reference to exhibit 10.31 of our Form 10-K for the year ended December 31, 2005 * Form of Mercantile Bank of Michigan Executive Deferred Compensation Agreement, that has been entered into between our bank and each of Gerald R. Johnson, Jr., Michael H. Price, Robert B. Kaminski, Jr., Charles E. Christmas, and certain other officers of our bank is incorporated by reference to exhibit 10.32 of our Form 10-K for the year ended December 31, 2005 * Form of Mercantile Bank of Michigan Split Dollar Agreement that has been entered into between our bank and each of Gerald R. Johnson, Jr., Michael H. Price, Robert B. Kaminski, Jr., Charles E. Christmas, and certain other officers of our bank is incorporated by reference to exhibit 10.33 of our Form 10-K for the year ended December 31, 2005 * Director Fee Summary * Lease Agreement between our bank and Joe D. Pentecost Trust dated April 29, 2005 for our East Lansing, Michigan office is incorporated by reference to exhibit 10.35 of our Form 10-K for the year ended December 31, 2005 Lease Agreement between our bank and The Conlin Company dated July 12, 2005 for our Ann Arbor, Michigan office is incorporated by reference to exhibit 10.36 of our Form 10-K for the year ended December 31, 2005 Stock Incentive Plan of 2006 is incorporated by reference to Appendix A of our proxy statement for our April 27, 2006 annual meeting of shareholders that was filed with the Securities and Exchange Commission * 24. EXHIBIT NO. 10.37 10.38 10.39 21 23 31 32.1 32.2 EXHIBIT DESCRIPTION Form of Notice of Grant of Incentive Stock Option and Stock Option Agreement for incentive stock options granted under our Stock Incentive Plan of 2006 is incorporated by reference to exhibit 10.1 of our Form 8-K dated November 22, 2006 * Form of Restricted Stock Award Agreement Notification of Award and Terms and Conditions of Award for restricted stock under our Stock Incentive Plan of 2006 is incorporated by reference to exhibit 10.2 of our Form 8-K dated November 22, 2006 * Executive Officer Bonus Plan for 2007 is incorporated by reference to exhibit 10.1 of our Form 8-K dated January 29, 2007 * Subsidiaries of the company Consent of Independent Registered Public Accounting Firm Rule 13a-14(a) Certifications Section 1350 Chief Executive Officer Certification Section 1350 Chief Financial Officer Certification * Management contract or compensatory plan (c) Financial Statements Not Included In Annual Report Not applicable 25. 43495MercantileBlank 2/23/07 8:49 AM Page 1 THIS PAGE LEFT INTENTIONALLY BLANK MERCANTILE BANK CORPORATION CONSOLIDATED FINANCIAL STATEMENTS December 31, 2006 and 2005 F-1 MERCANTILE BANK CORPORATION CONSOLIDATED FINANCIAL STATEMENTS December 31, 2006 and 2005 CONTENTS SELECTED FINANCIAL DATA........................................................................................................................ F-3 MANAGEMENT’S DISCUSSION AND ANALYSIS........................................................................................ F-4 REPORTS OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM............................................ F-26 REPORT BY MERCANTILE BANK CORPORATION’S MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING ................................................................................................ F-28 CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATED BALANCE SHEETS ..................................................................................................... F-29 CONSOLIDATED STATEMENTS OF INCOME....................................................................................... F-30 CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY .............................. F-31 CONSOLIDATED STATEMENTS OF CASH FLOWS ............................................................................. F-33 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ................................................................... F-35 F-2 SELECTED FINANCIAL DATA 2006 2005 2004 (Dollars in thousands except per share data) 2003 2002 Consolidated Results of Operations: Interest income Interest expense Net interest income Provision for loan and lease losses Noninterest income Noninterest expense Income before income tax expense Income tax expense Net income Consolidated Balance Sheet Data: Total assets Cash and cash equivalents Securities Loans and leases, net of deferred fees Allowance for loan and lease losses Bank owned life insurance policies $ 137,260 $ 102,130 46,838 55,292 3,790 5,661 31,117 26,046 8,145 $ 19,847 $ 17,901 75,673 61,587 5,775 5,261 32,262 28,811 8,964 $ 69,022 $ 54,658 $ 47,632 24,026 23,395 26,595 23,606 31,263 42,427 3,002 3,800 4,674 4,302 3,101 4,409 12,781 18,071 23,198 10,924 13,801 18,857 3,167 3,785 5,136 $ 13,721 $ 10,016 $ 7,757 $2,067,268 $1,838,210 $1,536,119 $1,203,337 $ 922,360 28,117 51,380 96,893 202,419 771,554 1,745,478 10,890 21,411 14,876 30,858 20,811 16,564 121,510 152,965 1,317,124 1,035,963 14,379 17,819 16,441 23,750 36,753 181,614 1,561,812 20,527 28,071 Deposits Securities sold under agreements to repurchase Federal Home Loan Bank advances Subordinated debentures Shareholders’ equity 1,646,903 85,472 95,000 32,990 171,915 1,419,352 72,201 130,000 32,990 155,125 1,159,181 56,317 120,000 32,990 141,617 902,892 49,545 90,000 16,495 130,201 754,113 50,335 15,000 16,495 79,834 Consolidated Financial Ratios: Return on average assets Return on average shareholders’ equity Average shareholders’ equity to average assets 1.01% 12.19% 8.31% 1.05% 12.05% 8.73% 0.99% 10.16% 9.79% 0.96% 10.61% 9.00% 0.97% 10.30% 9.45% Nonperforming loans and leases to total loans and leases Allowance for loan and lease losses to total loans and leases 0.49% 1.23% 0.26% 1.31% 0.22% 1.35% 0.17% 1.39% 0.10% 1.41% Tier 1 leverage capital Tier 1 leverage risk-based capital Total risk-based capital 10.04% 10.37% 11.45% 10.45% 10.82% 12.00% 11.53% 11.82% 13.03% 12.49% 12.60% 13.84% 10.72% 10.85% 12.10% Per Share Data: Net Income: Basic Diluted Book value at end of period Dividends declared Dividend payout ratio NA – Not Applicable $ 2.48 $ 2.45 $ 2.25 2.20 1.73 $ 1.69 1.49 $ 1.46 1.23 1.22 21.43 0.51 20.34% 19.46 0.41 17.79% 17.78 0.32 18.60% 16.40 0.27 18.41% 12.66 NA NA F-3 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FORWARD-LOOKING STATEMENTS The following discussion and other portions of this Annual Report contain forward-looking statements that are based on management’s beliefs, assumptions, current expectations, estimates and projections about the financial services industry, the economy, and about 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 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; changes in tax laws; changes in prices, levies, and assessments; 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 the national and local economies; and other risk factors described in Item 1A of this Annual Report. These are representative of the Future Factors that could cause a difference between an ultimate actual outcome and a preceding forward-looking statement. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The Management’s Discussion and Analysis of Financial Condition and Results of Operations is based on Mercantile Bank Corporation’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan and lease losses, and actual results could differ from those estimates. The allowance for loan and lease losses is maintained at a level we believe is adequate to absorb probable incurred losses identified and inherent in the loan and lease portfolio. Our evaluation of the adequacy of the allowance for loan and lease losses is an estimate based on reviews of individual loans, assessments of the impact of current and anticipated economic conditions on the portfolio, and historical loss experience. The allowance for loan and lease losses represents management’s best estimate, but significant downturns in circumstances relating to loan and lease quality or economic conditions could result in a requirement for an increased allowance for loan and lease losses in the near future. Likewise, an upturn in loan and lease quality or improved economic conditions may result in a decline in the required allowance for loan and lease losses. In either instance, unanticipated changes could have a significant impact on operating earnings. The allowance for loan and lease losses is increased through a provision charged to operating expense. Uncollectible loans and leases are charged-off through the allowance for loan and lease losses. Recoveries of loans and leases previously charged-off are added to the allowance for loan and lease losses. 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. Our policy for recognizing income on impaired loans is to accrue interest unless a loan is placed on nonaccrual status. F-4 INTRODUCTION This Management’s Discussion and Analysis should be read in conjunction with the consolidated financial statements contained in this Annual Report. This discussion provides information about the consolidated financial condition and results of operations of Mercantile Bank Corporation and its consolidated subsidiary, Mercantile Bank of Michigan (“our bank”), and of Mercantile Bank Mortgage Company, LLC (“our mortgage company”), Mercantile Bank Real Estate Co., L.L.C. (“our real estate company”) and Mercantile Insurance Center, Inc. (“our insurance company”), which are subsidiaries of our bank. Unless the text clearly suggests otherwise, references to “us,” “we,” “our,” or “the company” include Mercantile Bank Corporation and its wholly-owned subsidiaries referred to above. We were incorporated on July 15, 1997 as a bank holding company to establish and own our bank. Our bank, after receiving all necessary regulatory approvals, began operations on December 15, 1997. Our bank has a strong commitment to community banking and offers a wide range of financial products and services, primarily to small- to medium-sized businesses, as well as individuals. Our bank’s lending strategy focuses on commercial lending, and, to a lesser extent, residential mortgage and consumer lending. Our bank also offers a broad array of deposit products, including checking, savings, money market, and certificates of deposit, as well as security repurchase agreements. Our primary markets are the Grand Rapids, Holland, Lansing and Ann Arbor metropolitan areas. Our bank utilizes certificates of deposit from customers located outside of the primary market area to assist in funding the rapid asset growth our bank has experienced since inception. We formed a business trust, Mercantile Bank Capital Trust I (“the trust”), in 2004 to issue trust preferred securities. We issued subordinated debentures to the trust in return for the proceeds raised from the issuance of the trust preferred securities. In accordance with FASB Interpretation No. 46, the trust is not consolidated, but instead we report the subordinated debentures issued to the trust as a liability. Our mortgage company’s predecessor, Mercantile Bank Mortgage Company, was formed to increase the profitability and efficiency of the company’s mortgage loan operations. Mercantile Bank Mortgage Company initiated business on October 24, 2000 from our bank’s contribution of most of its residential mortgage loan portfolio and participation interests in certain commercial mortgage loans. On the same date, our bank had also transferred its residential mortgage origination function to Mercantile Bank Mortgage Company. On January 1, 2004, Mercantile Bank Mortgage Company was reorganized as Mercantile Bank Mortgage Company, LLC, a limited liability company. Mortgage loans originated and held by our mortgage company are serviced by our bank pursuant to a servicing agreement. Our insurance company acquired, at nominal cost, an existing shelf insurance agency effective April 15, 2002. An Agency and Institution Agreement was entered into among our insurance company, our bank and Hub International for the purpose of providing programs of mass marketed personal lines of insurance. Insurance product offerings include private passenger automobile, homeowners, personal inland marine, boat owners, recreational vehicle, dwelling fire, umbrella policies, small business and life insurance products, all of which are provided by and written through companies that have appointed Hub International as their agent. Our real estate company was organized on July 21, 2003, principally to develop, construct and own our new facility in downtown Grand Rapids which serves as our bank’s new main office and Mercantile Bank Corporation’s headquarters. Construction was completed during the second quarter of 2005. FINANCIAL CONDITION We continued to experience strong asset growth during 2006. Assets increased from $1,838.2 million on December 31, 2005 to $2,067.3 million on December 31, 2006. This represents an increase in total assets of $229.1 million, or 12.5%. The increase in total assets was primarily comprised of a $182.8 million increase in net loans and leases, a $20.8 million increase in securities and a $14.6 million increase in cash and cash equivalents. The increase in assets was primarily funded by a $227.6 million increase in deposits, a $13.3 million increase in repurchase agreements and a $16.8 million increase in shareholders’ equity. F-5 Earning Assets Average earning assets equaled 94.9% of average total assets during 2006, compared to 94.8% during 2005. Although we experienced strong asset growth during 2006, the asset composition remained relatively constant. The loan portfolio continued to comprise a majority of earning assets, followed by securities and federal funds sold. Our loan and lease portfolio, which equaled 89.2% of average earnings assets during 2006, is primarily comprised of commercial loans and leases. Constituting over 92% of loans and leases and growing by $177.3 million during 2006, the commercial loan and lease portfolio represents loans to businesses generally located within our market areas. Approximately 70% of the commercial loan and lease portfolio is primarily secured by real estate properties, with the remaining generally secured by other business assets such as accounts receivable, inventory, and equipment. The continued significant concentration of the loan and lease portfolio in commercial loans and leases and the strong growth of this portion of our lending business are consistent with our strategy of focusing a substantial amount of our efforts on “wholesale” banking. Corporate and business lending continues to be an area of expertise for our senior management team, and our commercial lenders have extensive commercial lending experience, with most having at least ten years’ experience. Of each of the loan categories that we originate, commercial loans and leases are most efficiently originated and managed, thus limiting overhead costs by necessitating the attention of fewer full-time employees. Our commercial lending business generates the greatest amount of local deposits and is virtually our only source of significant demand deposits. Residential mortgage and consumer loans, while equaling less than 8% of total loans and leases during 2006, also experienced strong growth; however, while we expect the residential mortgage loan and consumer loan portfolios to increase in future periods, the commercial sector of the lending efforts and resultant assets are expected to remain the dominant loan portfolio category given our wholesale banking strategy. The following tables present the maturity of total loans outstanding as of December 31, 2006, according to scheduled repayments of principal on fixed rate loans and repricing frequency on variable rate loans. Floating rate loans that are currently at interest rate ceilings, totaling $281.0 million as of December 31, 2006, are treated as fixed rate loans and are reflected using maturity date and not repricing frequency. Construction and land development Real estate – secured by 1-4 family properties Real estate – secured by multi-family properties Real estate – secured by nonresidential properties Commercial Leases Consumer 0-1 Year 1-5 Years After 5 Years Total $ 246,656,000 $ 33,858,000 $ 13,142,000 $ 293,656,000 64,832,000 53,131,000 13,681,000 131,644,000 16,005,000 14,566,000 432,000 31,003,000 310,559,000 380,139,000 33,000 3,303,000 466,547,000 86,222,000 1,355,000 4,208,000 31,153,000 4,911,000 0 745,000 808,259,000 471,272,000 1,388,000 8,256,000 $ 1,021,527,000 $ 659,887,000 $ 64,064,000 $ 1,745,478,000 Fixed rate loans Floating rate loans $ 93,126,000 $ 658,425,000 $ 64,064,000 $ 928,401,000 1,462,000 0 815,615,000 929,863,000 $ 1,021,527,000 $ 659,887,000 $ 64,064,000 $ 1,745,478,000 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 the internal “Watch List.” Senior management reviews this list regularly. F-6 Although the level of net loan and lease charge-offs and nonperforming loans and leases increased during 2006, the quality of our loan portfolio remains good. The levels of net loan and lease charge-offs and nonperforming loans and leases approximated banking industry averages during 2006, compared to levels that were below banking industry averages in prior years. As of December 31, 2006, nonperforming loans and leases totaled $8.6 million, or 0.49% of total loans and leases. At December 31, 2005, nonperforming loans and leases totaled $4.0 million, or 0.26% of total loans and leases. Net loan and lease charge-offs during 2006 totaled $4.9 million, or 0.29% of average total loans and leases. During 2005, net loan and lease charge-offs totaled $1.1 million, or 0.08% of average total loans and leases. Over 98% of the loan and lease portfolio consists of loans and leases extended directly to companies or individuals doing business and residing within our market areas. The remaining portion is comprised of commercial loans participated with certain unaffiliated commercial banks outside of our market areas, which are underwritten using the same loan criteria as though our bank was the originating bank. The following table summarizes nonperforming loans and leases and troubled debt restructurings. Loans and leases on nonaccrual status Loans and leases 90 days or more past due and accruing interest Troubled debt restructurings December 31,2006 December 31, 2005 December 31, 2004 December 31, 2003 December 31, 2002 $ 7,752,000 $ 3,601,000 $ 2,842,000 $ 233,000 $ 796,000 819,000 394,000 0 1,552,000 0 0 0 0 0 0 Total $ 8,571,000 $ 3,995,000 $ 2,842,000 $ 1,785,000 $ 796,000 F-7 The following table summarizes changes in the allowance for loan and lease losses for the past five years. 2006 2005 2004 2003 2002 Loan and leases outstanding at year-end $ 1,745,478,000 $ 1,561,812,000 $1,317,124,000 $1,035,963,000 $ 771,554,000 Daily average balance of loans and leases outstanding Balance of allowance at beginning of year Loans and leases charged-off: Commercial, financial and agricultural Construction and land development Leases Residential real estate Instalment loans to individuals Total loans and leases charged-off Recoveries of previously charged-off loans and leases: Commercial, financial and agricultural Construction and land development Leases Residential real estate Instalment loans to individuals Total recoveries $ 1,660,284,000 $ 1,432,609,000 $1,177,568,000 $ 887,512,000 $ 669,781,000 $ 20,527,000 $ 17,819,000 $ 14,379,000 $ 10,890,000 $ 8,494,000 (5,208,000) 0 0 (50,000) (131,000) (5,389,000) (718,000) (521,000) 0 (131,000) (22,000) (1,392,000) (1,328,000) 0 0 (16,000) (61,000) (1,405,000) (696,000) (471,000) 0 0 0 0 (26,000) 0 (10,000) (99,000) (706,000) (596,000) 487,000 0 0 2,000 9,000 498,000 298,000 2,000 0 6,000 4,000 310,000 150,000 0 0 0 21,000 171,000 257,000 0 0 22,000 6,000 285,000 78,000 0 0 4,000 18,000 100,000 Net charge-offs (4,891,000) (1,082,000) (1,234,000) (311,000) (606,000) Provision for loan and leases losses 5,775,000 3,790,000 4,674,000 3,800,000 3,002,000 Balance of allowance at year-end $ 21,411,000 $ 20,527,000 $ 17,819,000 $ 14,379,000 $ 10,890,000 Ratio of net charge-offs during the period leases to average outstanding during the period loans and Ratio of allowance to loans and leases outstanding at end of the period (0.29%) (0.08%) (0.10%) (0.04%) (0.09%) 1.23% 1.31% 1.35% 1.39% 1.41% In each accounting period, we adjust the allowance to the amount we believe is necessary to maintain the allowance at adequate levels. Through the loan and lease review and credit departments, we attempt to allocate specific portions of the allowance based on specifically identifiable problem loans and leases. The evaluation of the allowance is further based on, but not limited to, consideration of the internally prepared Reserve Analysis, composition of the loan and lease portfolio, third party analysis of the loan and lease administration processes and portfolio and general economic conditions. In addition, the strong commercial loan and leases growth is taken into account. The Reserve Analysis, used since our inception and completed monthly, applies reserve allocation factors to outstanding loan and lease balances to calculate an overall allowance dollar amount. For commercial loans and leases, which continue to comprise a vast majority of our total loans and leases, reserve allocation factors are based upon the loan ratings as determined by our standardized grade paradigms. For retail loans, reserve allocation factors are based upon the type of credit. Adjustments for specific lending relationships, including impaired loans and leases, are made on a case-by-case basis. The reserve allocation factors are primarily based on the recent levels and historical trends of net loan charge-offs and non-performing assets, the comparison of the recent levels and historical trends of net loan charge-offs and non-performing assets with a customized peer group consisting of ten similarly- sized publicly traded banking organizations conducting business in the states of Michigan, Illinois, Indiana and/or Ohio, the review and consideration of our loan migration analysis and the experience of senior management making similar loans and leases for an extensive period of time. We regularly review the Reserve Analysis and make adjustments periodically based upon identifiable trends and experience. F-8 The following table illustrates the breakdown of the allowance balance to loan type (dollars in thousands) and of the total loan and lease portfolio (in percentages). December 31, 2006 December 31, 2005 December 31, 2004 December 31, 2003 December 31, 2002 Amount Loan Portfolio Amount Loan Portfolio Amount Loan Portfolio Amount Loan Portfolio Amount Loan Portfolio Commercial, financial and agricultural Construction and land development $ 15,706 75.1% $ 16,507 76.9% $15,457 79.8% $12,220 79.0% $ 9,188 77.9% 3,975 16.8 2,868 14.5 1,581 10.3 1,571 11.4 1,143 13.5 Leases 15 0.1 30 0.1 39 0.2 26 0.2 11 0.1 Residential real estate Instalment loans to individuals 1,591 7.5 1,020 8.2 557 9.3 450 8.9 443 7.9 124 0.5 102 0.3 185 0.4 112 0.5 105 0.6 Unallocated 0 NA 0 NA 0 NA 0 NA 0 NA Total $ 21,411 100.0% $ 20,527 100.0% $17,819 100.0% $14,379 100.0% $10,890 100.0% The primary risk elements with respect to commercial loans and leases are the financial condition of the borrower, the sufficiency of collateral, and lack of timely payment. We have a policy of requesting and reviewing periodic financial statements from commercial loan and lease customers, and we periodically review the existence of collateral and its value. The primary risk element with respect to each instalment and residential real estate loan is lack of timely payment. We have a reporting system that monitors past due loans and have adopted policies to pursue creditor’s rights in order to preserve our bank’s position. Although we believe that the allowance is adequate to sustain losses as they arise, there can be no assurance that our bank will not sustain losses in any given period that could be substantial in relation to, or greater than, the size of the allowance. The securities portfolio also experienced strong growth during 2006, increasing from $181.6 million on December 31, 2005 to $202.4 million at December 31, 2006. During 2006, the securities portfolio equaled 10.2% of average earning assets. We maintain the portfolio at levels to provide adequate pledging for the repurchase agreement program and secondary liquidity for our daily operations. In addition, the portfolio serves a primary interest rate risk management function. At December 31, 2006, the portfolio was comprised of high credit quality U.S. Government Agency issued bonds (38%), municipal general obligation and revenue bonds (32%), U.S. Government Agency issued and guaranteed mortgage-backed securities (26%), Federal Home Loan Bank stock (4%) and a mutual fund (less than 1%). F-9 The following table reflects the composition of the securities portfolio, excluding Federal Home Loan Bank stock. December 31, 2006 December 31, 2005 December 31, 2004 Carrying Value Percentage Carrying Value Percentage Carrying Value Percentage $ 76,836,000 39.4% $ 63,712,000 36.7% $ 56,025,000 38.3% 53,083,000 27.2 48,237,000 27.7 37,801,000 25.9 56,870,000 29.2 53,685,000 30.9 45,063,000 30.8 7,073,000 3.6 7,081,000 4.1 7,278,000 5.0 U.S. Government agency debt obligations Mortgage-backed securities Municipal general obligations Municipal revenue bonds Mutual fund 1,048,000 0.6 1,012,000 0.6 0 NA Total $ 194,910,000 100.0% $ 173,727,000 100.0% $ 146,167,000 100.0% All securities, with the exception of tax-exempt municipal bonds, have been designated as “available for sale” as defined in Financial Accounting Standards Board Standard (SFAS) No. 115, Accounting for Certain Investments in Debt and Equity Securities. Securities designated as available for sale are stated at fair value, with the unrealized gains and losses, net of income tax, reported as a separate component of shareholders’ equity in accumulated other comprehensive income. The fair value of securities designated as available for sale at December 31, 2006 and 2005 was $131.0 million and $113.0 million, respectively. The net unrealized loss recorded at December 31, 2006 was $1.7 million, compared to the net unrealized loss of $2.2 million as of December 31, 2005. All tax-exempt municipal bonds have been designated as “held to maturity” as defined in SFAS No. 115, and are stated at amortized cost. As of December 31, 2006 and 2005, held to maturity securities had an amortized cost of $63.9 million and $60.8 million and a fair value of $65.0 million and $62.9 million, respectively. The following table shows by class of maturities as of December 31, 2006, the amounts and weighted average yields of investment securities (1): U.S. Treasury securities and obligations of U.S. Government agencies and corporations One year or less Over one through five years Over five through ten years Over ten years Obligations of states and political subdivisions One year or less Over one through five years Over five through ten years Over ten years Mortgage-backed securities Mutual fund Carrying Value Average Yield (Dollars in thousands) $ 0 17,647,000 59,189,000 0 76,836,000 2,593,000 8,798,000 11,533,000 41,019,000 63,943,000 53,083,000 1,048,000 NA 4.72% 5.21 NA 5.10 7.11 6.87 6.38 6.39 6.48 5.03 4.36 $ 194,910,000 5.53% (1) Yields on tax-exempt securities are computed on a fully taxable-equivalent basis. F-10 Federal funds sold, consisting of excess funds sold overnight to correspondent banks, are used to manage daily liquidity needs and interest rate sensitivity. During 2006, the average balance of these funds equaled 0.5% of average earning assets, unchanged from the level during 2005. The levels maintained during 2006 and 2005 are well within our internal policy guidelines, and future levels are not expected to change significantly. Cash and due from bank balances increased from $36.2 million at December 31, 2005, to $51.4 million on December 31, 2006, an increase of $15.2 million. The increase was primarily the result of larger amounts of deposits made by our deposit customers on the last business day of 2006 when compared to the last business day of 2005. Our commercial lending and wholesale funding focus results in relatively large day-to-day fluctuations of our cash and due from bank balances; however, relative to our asset size the average balances are generally stable. Cash and due from bank balances averaged $38.3 million, or 2.0% of average assets during 2006, compared to $36.8 million, or 2.2% of average assets, during 2005. Net premises and equipment increased from $30.2 million at December 31, 2005, to $33.5 million on December 31, 2006, an increase of $3.3 million. The increase primarily reflects the land acquisition and initial construction costs associated with our new office facility currently under construction in East Lansing, Michigan. Construction on this new facility is expected to be completed during the second quarter of 2007. Source of Funds Our major sources of funds are from deposits, repurchase agreements and Federal Home Loan Bank (“FHLB”) advances. Total deposits increased from $1,419.4 million at December 31, 2005, to $1,646.9 million on December 31, 2006, an increase of $227.5 million, or 16.0%. Included within these numbers is the success we achieved in generating deposit growth from customers located within our market areas during 2006. Local deposits increased from $456.5 million at December 31, 2005, to $633.1 million on December 31, 2006, an increase of $176.6 million, or 38.7%. Despite this success in obtaining funds from local customers, the substantial asset growth has necessitated the continued acquisition of funds from depositors outside of our market areas and FHLB advances. Out-of-area deposits increased from $962.8 million at December 31, 2005, to $1,013.8 million on December 31, 2006, an increase of $51.0 million, or 5.3%. Repurchase agreements increased from $72.2 million at December 31, 2005, to $85.5 million on December 31, 2006, an increase of $13.3 million, or 18.4%. FHLB advances decreased from $130.0 million at December 31, 2005, to $95.0 million on December 31, 2006, a decrease of $35.0 million, or 26.9%. At December 31, 2006, local deposits and repurchase agreements equaled 38.4% of total funding liabilities, compared to 31.8% on December 31, 2005. During 2006, we experienced strong growth in our noninterest-bearing checking deposit accounts. Comprised primarily of business loan customers, noninterest-bearing checking deposit accounts grew $12.4 million, or 10.2%, and equaled 6.4% of average total liabilities during 2006. Interest-bearing checking accounts increased $0.2 million, or 0.4%, and equaled 2.0% of average total liabilities during 2006. Money market deposit accounts decreased $0.9 million, or 9.0%, and equaled 0.6% of average total liabilities during 2006. Business loan customers also comprise the majority of interest-bearing checking and money market deposit accounts, although to a lesser extent than noninterest-bearing checking accounts. Pursuant to Federal law and regulations, incorporated businesses may not own interest-bearing checking accounts and transactions from money market accounts are limited. We anticipate continued overall growth of our check-writing deposit accounts as additional business loans are extended and through the efforts of our branch network and business development activities. During 2006, savings account balances recorded a decrease of $13.9 million, or 13.1%, and equaled 5.2% of average total liabilities. The decline in savings account balances during 2006 is primarily due to customers opening certificates of deposit with funds from their savings accounts, as rates offered on certificates of deposit have risen at a faster pace than rates offered on savings accounts. Business loan customers also comprise the majority of savings account holders, although to a lesser extent than check-writing accounts. While we anticipate an increase in savings account balances as additional business loans are extended and through the efforts of our branch network and business development activities, the increase may be negatively impacted by potential continued fund transfers to certificate of deposit products. F-11 Certificates of deposit purchased by customers located within our market areas increased significantly during 2006, growing from $179.3 million at December 31, 2005, to $358.2 million on December 31, 2006, an increase of $178.9 million, or 99.8%. These deposits accounted for 15.9% of average total liabilities during 2006. The growth was attributable to individuals, businesses and municipalities, and includes new monies to our bank from existing and new customers as well as transfers from existing savings accounts. The increase in local municipality certificates of deposit has been facilitated by our qualifying for funds from new municipal customers and additional funds from existing customers through a combination of our asset growth and increased profitability as measured by the municipalities’ investment policy guidelines, and is a trend that we expect to continue. During 2006, certificates of deposit obtained from customers located outside of our market areas increased by $51.0 million, and represented 55.9% of average total liabilities. At December 31, 2006, out-of-area deposits totaled $1,013.8 million. Out-of-area deposits consist primarily of certificates of deposit placed by deposit brokers for a fee, but also include certificates of deposit obtained from the deposit owners directly. The owners of the out-of-area deposits include individuals, businesses and governmental units located throughout the country. Out-of-area deposits are utilized to support our asset growth, and are generally a lower cost source of funds when compared to the interest rates that would have to be offered in the local market to generate a sufficient level of funds. During most of 2006, rates paid on new out-of-area deposits were very similar to rates paid on new certificates of deposit issued to local customers. In addition, the overhead costs associated with the out-of-area deposits are considerably less than the overhead costs that would be incurred to administer a similar level of local deposits. Although local deposits have and are expected to increase as new business, governmental and individual deposit relationships are established and as existing customers increase the balances in their deposit accounts, the relatively high reliance on out-of-area deposits will likely remain. Repurchase agreements increased $13.3 million and equaled 4.0% of average total liabilities during 2006. As part of our sweep account program, collected funds from certain business noninterest-bearing checking accounts are invested in overnight interest-bearing repurchase agreements. Although not considered a deposit account and therefore not afforded federal deposit insurance, the repurchase agreements are a means of providing a return for business customers that are not permitted to have an interest-bearing checking account. FHLB advances decreased $35.0 million and equaled 6.8% of average total liabilities during 2006. 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 at December 31, 2006 totaled $322.6 million. We first started to use FHLB advances in late 2002, and expect to continue to use this funding source, along with out-of-area certificates of deposit, as part of our wholesale funding program. Shareholders’ equity increased $16.8 million and equaled 8.3% of average assets during 2006. The increase was primarily attributable to net income from operations. Net income from operations totaled $19.8 million during 2006. Also positively impacting shareholders’ equity was a $0.3 million mark-to-market adjustment for available for sale securities as defined in SFAS No. 115, plus proceeds totaling $0.4 million relating to stock option exercises and our dividend reinvestment and employee stock purchase plans. Negatively impacting shareholders’ equity during 2006 was the payment of cash dividends, which totaled $4.0 million. RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2006 and 2005 Summary We recorded strong earnings performance during 2006. Net income was $19.8 million, or $2.48 per basic share and $2.45 per diluted share. This earnings performance compares favorably to net income of $17.9 million, or $2.25 per basic share and $2.20 per diluted share, recorded in 2005. The $1.9 million improvement in net income represents an increase of 10.9%, while diluted earnings per share were up 11.4%. The earnings improvement during 2006 over that of 2005 is primarily attributable to higher net interest income, which more than offset increases in provision expense and overhead costs. F-12 The following table shows some of the key performance and equity ratios for the years ended December 31, 2006 and 2005. Return on average total assets Return on average equity Dividend payout ratio Average equity to average assets 2006 2005 1.01% 12.19 20.34 8.31 1.05% 12.05 17.79 8.73 Net Interest Income Net interest income, the difference between revenue generated from earning assets and the interest cost of funding those assets, is our primary source of earnings. Interest income (adjusted for tax-exempt income) and interest expense totaled $138.5 million and $75.7 million during 2006, respectively, providing for net interest income of $62.8 million. This performance compares favorably to that of 2005 when interest income and interest expense were $103.2 million and $46.8 million, respectively, providing for net interest income of $56.4 million. In comparing 2006 with 2005, interest income increased 34.1%, interest expense was up 61.6% and net interest income increased 11.3%. The level of net interest income is primarily a function of asset size, as the weighted average interest rate received on earning assets is greater than the weighted average interest cost of funding sources; however, factors such as types of assets and liabilities, interest rate environment, interest rate risk, common stock sales, liquidity, and customer behavior also impact net interest income as well as the net interest margin. The net interest margin declined from 3.50% in 2005 to 3.37% in 2006, a decrease of 3.7%. Our net interest margin during 2004 was 3.30%. Throughout 2005 and during the first half of 2006, our net interest margin was generally on an increasing trend. From June 2004 through June 2006, the Federal Open Market Committee (“FOMC”) increased the federal funds rate by 25 basis points at 17 consecutive meetings, causing the prime rate to increase from 4.00% in June 2004 to 8.25% in June 2006. Our yield on assets increased significantly during this time period, as the interest rates on over 70% of our total loans and leases were tied to the prime rate. Our cost of funds also increased during this time period, as interest rates paid on our deposits and borrowings increased as well. However, our cost of funds increased at a slower rate than the increase in our yield on assets, with a significant portion of our interest-bearing liabilities comprised of fixed rate certificates of deposit and borrowings, resulting in a lagged increased cost of funds. The FOMC has left the federal funds rate unchanged since June 2006, resulting in a relatively steady yield on assets. However, our cost of funds has continued to increase as maturing fixed rate certificates of deposit and borrowings, which were obtained during lower interest rate environments, are replaced or renewed at higher interest rates. Assuming no major changes in the federal funds rate in the near future, we expect our cost of funds, and therefore our net interest margin, to level-out during the second quarter of 2007. The following table depicts the average balance, interest earned and paid, and weighted average rate of our assets, liabilities and shareholders’ equity during 2006, 2005 and 2004. The table also depicts the dollar amount of change in interest income and interest expense of interest-earning assets and interest-bearing liabilities, segregated between change due to volume and change due to rate. For tax-exempt investment 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 $1.2 million, $1.1 million and $1.0 million in 2006, 2005 and 2004, respectively. F-13 (Dollars in thousands) Years ended December 31, ----------------------2 0 0 6----------------- Average Rate Average Balance Interest -----------------------2 0 0 5 ----------------- Average Rate Average Balance Interest ---------------------- 2 0 0 4 ----------------- Average Rate Average Balance Interest Taxable securities $ 128,382 $ Tax-exempt securities Total securities 61,949 190,331 6,557 5.11% $ 114,097 $ 5,588 4.90% $ 82,107 $ 3,935 4.79% 3,930 10,487 6.34 5.51 58,005 172,102 3,703 9,291 6.38 5.40 48,322 130,429 3,174 7,109 6.57 5.45 Loans and leases Short-term investments Federal funds sold Total earning assets Allowance for loan and lease losses Cash and due from banks Other non-earning assets 1,660,284 127,470 7.68 1,432,609 93,666 6.54 1,177,568 62,791 5.33 320 9,745 12 482 3.75 4.95 582 8,156 14 266 2.41 3.26 593 5,942 4 75 0.67 1.26 1,860,680 138,451 7.44 1,613,449 103,237 6.40 1,314,532 69,979 5.32 (21,464) 38,298 82,419 (19,048) 36,827 70,769 (16,203) 31,587 49,262 Total assets $ 1,959,933 $ 1,701,997 $ 1,379,178 Interest-bearing demand deposits $ Savings deposits Money market accounts Time deposits Total interest- bearing deposits 10,326 1,289,777 1,429,679 75,885 Short-term borrowings Federal Home Loan Bank advances Long-term borrowings Total interest- bearing liabilities 1,663,391 121,932 35,895 36,530 $ 93,046 1,069 3,328 2.93% 3.58 $ 36,319 $ 113,945 707 2,934 1.95% 2.57 $ 32,994 $ 136,214 427 2,497 1.29% 1.83 325 60,033 3.15 4.65 9,478 1,036,457 211 35,032 2.23 3.38 8,788 780,867 129 18,733 1.47 2.40 64,755 4.53 1,196,199 38,884 3.25 958,863 21,786 2.27 2,867 3.78 66,814 1,795 2.69 55,816 877 1.57 5,393 4.42 131,137 4,200 3.20 112,869 2,471 2.19 2,658 7.40 35,014 1,959 5.59 18,938 1,461 7.71 75,673 4.55 1,429,164 46,838 3.28 1,146,486 26,595 2.32 Demand deposits Other liabilities Total liabilities Average equity Total liabilities and equity 115,390 18,371 1,797,152 162,781 $ 1,959,933 111,892 12,352 1,553,408 148,589 $ 1,701,997 90,534 7,156 1,244,176 135,002 $ 1,379,178 Net interest income Rate spread Net interest margin $ 62,778 $ 56,399 $ 43,384 2.89% 3.37% 3.12% 3.50% 3.00% 3.30% F-14 --------------------2006 over 2005 -------------------- Volume Total Rate -------------------- 2005 over 2004-------------------- Volume Total Rate Years ended December 31, Increase (decrease) in interest income Taxable securities Tax exempt securities Loans Short term investments Federal funds sold Net change in tax-equivalent $ 969,000 227,000 33,804,000 (2,000) 216,000 $ 722,000 250,000 16,123,000 (8,000) 59,000 $ 247,000 (23,000) 17,681,000 6,000 157,000 $ 1,653,000 529,000 30,875,000 10,000 191,000 $ 1,565,000 620,000 15,104,000 0 36,000 $ 88,000 (91,000) 15,771,000 10,000 155,000 income 35,214,000 17,146,000 18,068,000 33,258,000 17,325,000 15,933,000 Increase (decrease) in interest expense Interest-bearing demand deposits Savings deposits Money market accounts Time deposits Short term borrowings Federal Home Loan Bank advances Long term borrowings Net change in interest 362,000 394,000 114,000 25,001,000 1,072,000 4,000 (605,000) 20,000 9,832,000 268,000 358,000 999,000 94,000 15,169,000 804,000 280,000 437,000 82,000 16,299,000 918,000 47,000 (456,000) 11,000 7,246,000 199,000 233,000 893,000 71,000 9,053,000 719,000 1,193,000 699,000 (312,000) 50,000 1,505,000 649,000 1,729,000 498,000 448,000 983,000 1,281,000 (485,000) expense 28,835,000 9,257,000 19,578,000 20,243,000 8,478,000 11,765,000 Net change in tax-equivalent net interest income $ 6,379,000 $ 7,889,000 $ (1,510,000) $ 13,015,000 $ 8,847,000 $ 4,168,000 Interest income is primarily generated from the loan and lease portfolio, and to a lesser degree from securities, federal funds sold and short term investments. Interest income increased $35.3 million during 2006 from that earned in 2005, totaling $138.5 million in 2006 compared to $103.2 million in the previous year. The increase is primarily due to the growth in earning assets and a higher interest rate environment during 2006 when compared to 2005. Reflecting the higher interest rate environment, the yield on average earning assets increased from 6.40% recorded in 2005 to 7.44% in 2006. The growth in interest income is primarily attributable to an increase in earning assets and an increase in earning asset yields. During 2006, average earning assets increased $247.3 million, increasing from $1,613.4 million in 2005 to $1,860.7 million during 2006. Growth in average total loans and leases, totaling $227.7 million, comprised 92.1% of the increase in average earning assets during 2006. Interest income generated from the loan and lease portfolio increased $33.8 million during 2006 over the level earned in 2005, comprised of an increase of $16.1 million from the growth in the loan and lease portfolio and an increase of $17.7 million due to the increase in the yield earned on the loan portfolio to 7.68% from 6.54%. The increase in the loan and lease portfolio yield is primarily due to a higher interest rate environment during 2006 than in 2005. Growth in the securities portfolio and an improved overall yield also added to the increase in interest income during 2006 over that of 2005. Average securities increased by $18.2 million in 2006, increasing from $172.1 million in 2005 to $190.3 million in 2006. The growth equated to an increase in interest income of $1.0 million, while an improved yield earned on the securities portfolio from 5.40% to 5.51% increased interest income by $0.2 million. Interest income earned on federal funds sold increased by $0.2 million due to a small increase in the average balance and a higher yield during 2006. Interest expense is primarily generated from interest-bearing deposits, and to a lesser degree from repurchase agreements, FHLB advances and subordinated debentures. Interest expense increased $28.8 million during 2006 from that expensed in 2005, totaling $75.6 million in 2006 compared to $46.8 million in the previous year. The increase in interest expense is primarily attributable to the impact of an increase in interest-bearing liabilities and a higher interest rate environment during 2006 when compared to 2005. Interest-bearing liabilities averaged $1,663.4 million during 2006, or $234.2 million higher than the average interest-bearing liabilities of $1,429.2 million during 2005. This growth resulted in increased interest expense of $9.3 million. An increase in interest expense of $19.6 million was recorded during 2006 primarily due to a higher interest rate environment during 2006 than in 2005. The cost of average interest-bearing liabilities increased from the 3.28% recorded in 2005 to 4.55% in 2006. F-15 Average certificate of deposit growth during 2006 of $253.3 million equated to an increase in interest expense of $9.8 million, with an additional $15.2 million expensed due to the increase in the average rate paid as lower-rate certificates of deposit matured and were either renewed or replaced with higher-costing certificates of deposit throughout 2006. A decline in average savings deposits, totaling $20.9 million, equated to a decrease in interest expense of $0.6 million; however, interest expense of $1.0 million was recorded due to an increase in the average rate paid during 2006. Growth in average interest-bearing checking accounts of $0.2 million equated to a less than $0.1 million increase in interest expense, with an additional $0.4 million of interest expense recorded due to a higher average rate paid during 2006. Average short term borrowings, comprised of repurchase agreements and federal funds purchased, increased $9.1 million during 2006, resulting in increased interest expense of $0.3 million, with an additional interest expense of $0.8 million recorded due to an increase in the average rate paid during 2006. Average FHLB advances decreased $9.2 million, equating to a decrease in interest expense of $0.3 million, with an increased average rate adding $1.5 million to interest expense. Growth in average long-term borrowings, comprised of subordinated debentures and deferred director and officer compensation programs, equated to an increase in interest expense of less than $0.1 million during 2006, with an increased average rate adding $0.6 million to interest expense. Provision for Loan and Lease Losses The provision for loan and lease losses totaled $5.8 million during 2006, compared to the $3.8 million expensed during 2005. The increase primarily reflects an increase in the volume of loan and lease net charge-offs during 2006 when compared to 2005, partially offset by lower loan and lease growth in 2006. Net loan and lease charge-offs during 2006 totaled $4.9 million, or 0.29% of average total loans and leases. Net loan and lease charge-offs during 2005 totaled $1.1 million, or 0.08% of average total loans and leases. Loan and lease growth during 2006 equaled $183.7 million, compared to loan and lease growth of $244.7 million during 2005. The allowance as a percentage of total loans outstanding as of December 31, 2006 was 1.23%, compared to 1.31% at year-end 2005. In each accounting period, we adjust the allowance by the amount we believe is necessary to maintain the allowance at adequate levels. Through the loan and lease review and credit departments, we attempt to allocate specific portions of the allowance based on specifically identifiable problem loans and leases. The evaluation of the allowance is further based on, but not limited to, consideration of the internally prepared Reserve Analysis, composition of the loan and lease portfolio, third party analysis of the loan and lease administration processes and portfolio and general economic conditions. In addition, the strong commercial loan and leases growth is taken into account. The Reserve Analysis, used since our inception and completed monthly, applies reserve allocation factors to outstanding loan and lease balances to calculate an overall allowance dollar amount. For commercial loans and leases, which continue to comprise a vast majority of our total loans and leases, reserve allocation factors are based upon the loan ratings as determined by our standardized grade paradigms. For retail loans, reserve allocation factors are based upon the type of credit. Adjustments for specific lending relationships, including impaired loans and leases, are made on a case-by-case basis. The reserve allocation factors are primarily based on the recent levels and historical trends of net loan charge-offs and non-performing assets, the comparison of the recent levels and historical trends of net loan charge-offs and non-performing assets with a customized peer group consisting of ten similarly- sized publicly traded banking organizations conducting business in the states of Michigan, Illinois, Indiana and/or Ohio, the review and consideration of our loan migration analysis and the experience of senior management making similar loans and leases for an extensive period of time. We regularly review the Reserve Analysis and make adjustments periodically based upon identifiable trends and experience. F-16 Noninterest Income Noninterest income totaled $5.3 million in 2006, a decrease of $0.4 million from the $5.7 million earned in 2005. Other noninterest income during 2005 included a one-time gain of $0.7 million which was recorded from the sale of state tax credits derived from the construction of the new main office in downtown Grand Rapids. Deposit and repurchase agreement service charges were unchanged in 2006 when compared to 2005; although the number of deposit accounts increased during 2006, the earnings credit rate also increased, reducing the level of fees paid by our depositors. Earnings from increased cash surrender value of bank owned life insurance policies increased $0.2 million in 2006, primarily reflecting a higher balance from the purchase of additional policies during the year. We recorded increases in virtually all other fee income-producing activities in 2006 when compared to 2005, with the exception of residential mortgage banking fees, which decreased $0.1 million due to lower volume of activity. Noninterest Expense Noninterest expense during 2006 totaled $32.3 million, an increase of $1.2 million over the $31.1 million expensed in 2005. Salary expense and benefit costs increased $0.3 million in 2006 when compared to 2005. Base compensation increased approximately $2.9 million, primarily reflecting the increase in full-time equivalent employees from 273 at year-end 2005 to 291 at year-end 2006 and annual pay increases. However, bonus expense declined $2.6 million during 2006 when compared to 2005. Occupancy, furniture and equipment costs increased $0.9 million in 2006, primarily reflecting a full year’s expense associated with the opening of our new main office in downtown Grand Rapids during the second quarter of 2005, and the opening of our new leased facilities in Lansing and Ann Arbor during the third quarter of 2005. All other non-interest expenses, in aggregate, were relatively unchanged in 2006 when compared to 2005. While the dollar amount of noninterest costs has increased, the growth of net interest income and fee income has increased more. Noninterest costs during 2006 were $1.2 million higher than the level of overhead costs expensed during 2005; however, net interest income and fee income increased a combined $5.9 million during the same time period. Monitoring and controlling our noninterest costs, while at the same time providing high quality service to our customers, is one of our priorities. The efficiency ratio, a banking industry standardized calculation that attempts to reflect the utilization of overhead costs, improved during 2006 and remained well below banking industry averages. Computed by dividing noninterest expenses by net interest income plus noninterest income, the efficiency ratio was 48.3% during 2006, compared to 51.1% during 2005. Federal Income Tax Expense Federal income tax expense was $9.0 million in 2006, an increase of $0.9 million over the $8.1 million expensed during 2005. The increase during 2006 is primarily due to the growth in our pre-federal income tax profitability. The effective tax rate for 2006 was 31.1%, compared to 31.3% in 2005. RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2005 AND 2004 Summary We recorded strong earnings performance during 2005. Net income was $17.9 million, or $2.25 per basic share and $2.20 per diluted share. This earnings performance compares favorably to net income of $13.7 million, or $1.73 per basic share and $1.69 per diluted share, recorded in 2004. The $4.2 million improvement in net income represents an increase of 30.5%, while diluted earnings per share were up 30.2%. The earnings improvement during 2005 over that of 2004 is primarily attributable to higher net interest income and a lower provision expense, which more than offset an increase in overhead costs. Net income for 2004 includes an $845,000 ($548,000 after-tax) write-off associated with the unamortized balance of issuance costs related to the redemption of the $16.0 million of 9.60% Cumulative Preferred Securities issued in 1999 by MBWM Capital Trust I. Excluding this one-time expense, net income for 2004 was $14.3 million ($1.80 per basic share and $1.76 per diluted share). We believe excluding the impact of the one-time charge from 2004 operating results and performance measures allows a more meaningful comparison of 2005 results to 2004 results; therefore, the following discussion of our results of operations for the years ended December 31, 2005 and December 31, 2004 includes both GAAP and non-GAAP facts and figures where appropriate. F-17 The following table shows some of the key performance and equity ratios for the years ended December 31, 2005 and 2004. Return on average total assets Return on average equity Dividend payout ratio Average equity to average assets 2005 2004 1.05% 12.05 17.79 8.73 0.99% 10.16 18.60 9.79 Net Interest Income Net interest income, the difference between revenue generated from earning assets and the interest cost of funding those assets, is our primary source of earnings. Interest income (adjusted for tax-exempt income) and interest expense totaled $103.2 million and $46.8 million during 2005, respectively, providing for net interest income of $56.4 million. This performance compares favorably to that of 2004 when interest income and interest expense were $70.0 million and $26.6 million, respectively, providing for net interest income of $43.4 million. In comparing 2005 with 2004, interest income increased 47.4%, interest expense was up 76.0% and net interest income increased 30.0%. The level of net interest income is primarily a function of asset size, as the weighted average interest rate received on earning assets is greater than the weighted average interest cost of funding sources; however, factors such as types of assets and liabilities, interest rate risk, common stock sales, liquidity, and customer behavior also impact net interest income as well as the net interest margin. The net interest margin improved from 3.30% in 2004 to 3.50% in 2005, an increase of 6.1%, primarily due to earning assets repricing faster than interest-bearing liabilities during the increasing interest rate environment that existed during virtually all of 2005. Interest income is primarily generated from the loan portfolio, and to a lesser degree from securities, federal funds sold and short term investments. Interest income increased $33.3 million during 2005 from that earned in 2004, totaling $103.2 million in 2005 compared to $70.0 million in the previous year. The increase is primarily due to the growth in earning assets and a higher interest rate environment during 2005 when compared to 2004. Reflecting the higher interest rates, the yield on average earning assets increased from 5.32% recorded in 2004 to 6.40% in 2005. The growth in interest income is primarily attributable to an increase in earning assets and an increase in earning asset yields. During 2005, average earning assets increased $298.9 million, increasing from $1,314.5 million in 2004 to $1,613.4 million during 2005. Growth in average total loans and leases, totaling $255.0 million, comprised 85.3% of the increase in average earning assets during 2005. Interest income generated from the loan and lease portfolio increased $30.9 million during 2005 over the level earned in 2004, comprised of an increase of $15.1 million from the growth in the loan and lease portfolio and an increase of $15.8 million due to the increase in the yield earned on the loan and lease portfolio to 6.54% from 5.33%. The increase in the loan and lease portfolio yield is primarily due to a higher interest rate environment during 2005 than in 2004. Growth in the securities portfolio, partially offset by a slightly lower yield, also added to the increase in interest income during 2005 over that of 2004. Average securities increased by $41.7 million in 2005, increasing from $130.4 million in 2004 to $172.1 million in 2005. The growth equated to an increase in interest income of $2.2 million, while a decrease in the yield earned on the securities portfolio from 5.45% to 5.40% reduced interest income by $0.1 million. Interest income earned on federal funds sold increased by $0.2 million due to a small increase in the average balance and a higher yield during 2005. Interest expense is primarily generated from interest-bearing deposits, and to a lesser degree from repurchase agreements, FHLB advances and subordinated debentures. Interest expense increased $20.2 million during 2005 from that expensed in 2004, totaling $46.8 million in 2005 compared to $26.6 million in the previous year. The increase in interest expense is primarily attributable to the impact of an increase in interest-bearing liabilities and a higher interest rate environment during 2005 when compared to 2004. Interest-bearing liabilities averaged $1,429.2 million during 2005, or $282.7 million higher than the average interest-bearing liabilities of $1,146.5 million during 2004. This growth resulted in increased interest expense of $8.5 million. An increase in interest expense of $11.7 million was recorded during 2005 primarily due to a higher interest rate environment during 2005 than in 2004. The cost of average interest-bearing liabilities increased from the 2.32% recorded in 2004 to 3.28% in 2005. F-18 Growth in average certificates of deposits, totaling $255.6 million, comprised 90.4% of the increase in average interest-bearing liabilities between 2005 and 2004. Average FHLB advances increased $18.2 million, or 6.4% of the increase in average interest-bearing liabilities in 2005. The certificate of deposit growth during 2005 equated to an increase in interest expense of $7.2 million, with an additional $9.1 million expensed due to the increase in the average rate paid as lower-rate certificates of deposit matured and were either renewed or replaced with higher- costing certificates of deposit during most of 2005. FHLB advance growth during 2005 equated to an increase in interest expense of $0.4 million, with an increased average rate adding an additional $1.3 million to interest expense. A decline in average savings deposits, totaling $22.3 million, equated to a decrease in interest expense of $0.5 million; however, interest expense of $0.9 million was recorded due to an increase in the average rate paid during 2005. Growth in average interest-bearing checking accounts of $3.3 million equated to a less than $0.1 million increase in interest expense, with an additional $0.2 million of interest expense recorded due to a higher average rate paid during 2005. Average short term borrowings, comprised of repurchase agreements and federal funds purchased, increased $11.0 million during 2005, resulting in increased interest expense of $0.2 million, with an additional interest expense of $0.7 million recorded due to an increase in the average rate paid during 2005. Growth of $16.1 million in average long-term borrowings, comprised primarily of subordinated debentures but also including deferred director and officer compensation programs, equated to an increase in interest expense of $1.0 million during 2005; however, a decline in the average rate paid on subordinated debentures resulting from the September 2004 refinance, equated to a $0.5 million reduction of interest expense during 2005. Provision for Loan and Lease Losses The provision for loan and lease losses totaled $3.8 million during 2005, compared to the $4.7 million expensed during 2004. The decline primarily reflects lower loan and lease loan growth and a decline in the volume of loan and lease net charge-offs during 2005 when compared to 2004. The allowance as a percentage of total loans outstanding as of December 31, 2005 was 1.31%, compared to 1.35% at year-end 2004. Loan and lease growth during 2005 equaled $244.7 million, compared to loan and lease growth of $281.2 million during 2004. Net loan and lease charge-offs during 2005 totaled $1.1 million, or 0.08% of average total loans and leases. Net loan and lease charge-offs during 2004 totaled $1.2 million, or 0.10% of average total loans and leases. In each accounting period, we adjust the allowance by the amount we believe is necessary to maintain the allowance at adequate levels. Through the loan and lease review and credit departments, we attempt to allocate specific portions of the allowance based on specifically identifiable problem loans and leases. The evaluation of the allowance is further based on, but not limited to, consideration of the internally prepared Reserve Analysis, composition of the loan and lease portfolio, third party analysis of the loan and lease administration processes and portfolio and general economic conditions. In addition, the strong commercial loan and leases growth is taken into account. The Reserve Analysis, used since our inception and completed monthly, applies reserve allocation factors to outstanding loan and lease balances to calculate an overall allowance dollar amount. For commercial loans and leases, which continue to comprise a vast majority of our total loans and leases, reserve allocation factors are based upon the loan ratings as determined by our standardized grade paradigms. For retail loans, reserve allocation factors are based upon the type of credit. Adjustments for specific lending relationships, including impaired loans and leases, are made on a case-by-case basis. The reserve allocation factors are primarily based on the recent levels and historical trends of net loan charge-offs and non-performing assets, the comparison of the recent levels and historical trends of net loan charge-offs and non-performing assets with a customized peer group consisting of ten similarly- sized publicly traded banking organizations conducting business in the states of Michigan, Illinois, Indiana and/or Ohio, the review and consideration of our loan migration analysis and the experience of senior management making similar loans and leases for an extensive period of time. We regularly review the Reserve Analysis and make adjustments periodically based upon identifiable trends and experience. F-19 Noninterest Income Noninterest income totaled $5.7 million in 2005, an increase of $1.4 million from the $4.3 million earned in 2004. Deposit and repurchase agreement service charges increased $0.1 million in 2005, primarily reflecting the growth in the number of deposit accounts and modest increases in the deposit fee structure. The cash surrender value of bank owned life insurance policies increased $0.3 million in 2005, primarily reflecting a higher balance from the purchase of additional policies during the year. Primarily reflecting an increase in volume of activity, residential mortgage banking fees increased $0.2 million during 2005. Other noninterest income includes a gain of $0.7 million which was recognized during 2005 from the sale of state tax credits derived from the construction of the new main office in downtown Grand Rapids. Noninterest Expense Noninterest expense during 2005 totaled $31.1million, an increase of $7.9 million over the $23.2 million expensed in 2004. Noninterest expense during 2004 includes an $845,000 write-off associated with the unamortized balance of issuance costs related to the redemption of the $16.0 million of 9.60% Cumulative Preferred Securities issued in 1999 by the MBWM Capital Trust I. Excluding this one-time write-off, noninterest expense during 2004 totaled $22.4 million, with the growth in overhead costs during 2005 equating to $8.7 million. Of the $8.7 million growth in overhead costs, $4.7 million (54.0% of total) was in salaries and benefits, which primarily reflects the increase in full-time equivalent employees from 194 at year-end 2004 to 273 at year-end 2005 and annual pay increases. Occupancy, furniture and equipment costs increased $1.6 million (18.4% of total) in 2005, primarily reflecting the opening of our Holland banking office in October of 2004, the opening of our new main office in downtown Grand Rapids during the second quarter of 2005, the opening of our new leased facilities in Lansing and Ann Arbor during the third quarter of 2005 and our increased staffing level. While the dollar amount of noninterest costs has increased, the growth of net interest income and fee income has increased more. Noninterest costs during 2005 were $8.7 million higher than the level of overhead costs expensed during 2004; however, net interest income and fee income increased a combined $14.2 million during the same time period. Monitoring and controlling our noninterest costs, while at the same time providing high quality service to our customers, is one of our priorities. The efficiency ratio, a banking industry standardized calculation that attempts to reflect the utilization of overhead costs, declined during 2004 but remained well below banking industry averages. Computed by dividing noninterest expenses by net interest income plus noninterest income, the efficiency ratio was 51.1% during 2005, compared to 49.6% during 2004. If the one-time write-off addressed above is excluded from the calculation, our 2004 efficiency ratio improves to 47.8%. The decline in the efficiency ratio is primarily related to the initial overhead costs associated with our expansion into Lansing and Ann Arbor, especially salary and benefit and occupancy expenses. Federal Income Tax Expense Federal income tax expense was $8.1 million in 2005, an increase of $3.0 million over the $5.1 million expensed during 2004. The increase during 2005 is primarily due to the growth in our pre-federal income tax profitability and an increase in the effective tax rate, the latter of which reflects a lower level of tax-exempt income as a percent of total income. CAPITAL RESOURCES Shareholders’ equity is a noninterest-bearing source of funds that provides support for our asset growth. Shareholders’ equity was $171.9 million and $155.1 million at December 31, 2006 and 2005, respectively. The $16.8 million increase during 2006 is primarily attributable to net income from operations. Net income from operations totaled $19.8 million during 2006. Also positively impacting shareholders’ equity was a $0.3 million mark-to-market adjustment for available for sale securities as defined in SFAS No. 115, plus proceeds totaling $0.4 million relating to stock option exercises and our dividend reinvestment and employee stock purchase plans. Negatively impacting shareholders’ equity during 2006 was the payment of cash dividends, which totaled $4.0 million. F-20 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. Our and our bank’s capital ratios as of December 31, 2006 and 2005 are disclosed under Note 16 on pages F-55 and F-56 of the Notes to Consolidated Financial Statements. Our ability to pay cash and stock dividends is subject to limitations under various laws and regulations and to prudent and sound banking practices. On April 11, 2006, we declared a 5% common stock dividend, payable on May 16, 2006 to record holders as of April 24, 2006. This represented the sixth consecutive year we have paid a 5% stock dividend. Also during 2006, we paid a cash dividend on our common stock each calendar quarter. These cash dividends totaled $0.51 per share for 2006, and $4.0 million in aggregate amount. On January 9, 2007, we declared a $0.14 per common share cash dividend that will be paid on March 9, 2007 to shareholders of record on February 9, 2007. LIQUIDITY Liquidity is measured by our ability to raise funds through deposits, borrowed funds, capital or cash flow from the repayment of loans and investment securities. These funds are used to meet deposit withdrawals, maintain reserve requirements, fund loans and operate our company. Liquidity is primarily achieved through the growth of deposits (both local and out-of-area) and liquid assets such as securities available for sale, matured securities, and federal funds sold. Asset and liability management is the process of managing the balance sheet to achieve a mix of earning assets and liabilities that maximizes profitability, while providing adequate liquidity. Our liquidity strategy is to fund loan growth with deposits, repurchase agreements and other borrowed funds and to maintain an adequate level of short- and medium-term investments to meet typical daily loan and deposit activity. Net deposit and repurchase agreement growth from customers located in our market areas increased by $189.8 million, or 35.9%, during 2006. This strong growth was not fully sufficient to meet the earning asset growth of $204.2 million. To assist in providing the additional needed funds, we regularly obtained certificates of deposit from customers outside of our market areas. As of December 31, 2006, out-of-area deposits totaled $1,013.8 million, an increase in dollar volume of $51.0 million from the $962.8 million outstanding at December 31, 2005. However, as a percent of combined total deposits and repurchase agreements, out-of-area deposits declined from 64.6% as of December 31, 2005 to 58.5% at December 31, 2006. As a member of the Federal Home Loan Bank of Indianapolis, our bank has access to the FHLB advance borrowing programs. As of December 31, 2006, advances totaled $95.0 million, compared to $130.0 million outstanding as of December 31, 2005. Our borrowing line of credit at December 31, 2006 totaled $322.6 million, with availability of $216.5 million. We have the ability to borrow money on a daily basis through correspondent banks using established federal funds purchased lines. During 2006, our federal funds purchased position averaged $3.7 million, compared to an average federal funds sold position of $9.7 million. At December 31, 2006, our established unsecured federal funds purchased lines totaled $72.0 million. F-21 The following table reflects, as of December 31, 2006, significant fixed and determinable contractual obligations to third parties by payment date. One Year or Less One to Three Years Three to Five Years Over Five Years Total Deposits without a stated maturity $ 274,919,000 $ 0 $ 0 $ 0 $ 274,919,000 Certificates of deposits 1,027,309,000 313,680,000 30,995,000 0 1,371,984,000 Short term borrowings 95,272,000 0 0 0 95,272,000 Federal Home Loan Bank advances 80,000,000 15,000,000 0 0 95,000,000 Subordinated debentures 0 0 0 32,990,000 32,990,000 Other borrowed money 0 0 0 3,316,000 3,316,000 Operating leases 207,000 324,000 83,000 0 614,000 In addition to normal loan funding and deposit flow, we also need to maintain liquidity to meet the demands of certain unfunded loan commitments and standby letters of credit. At December 31, 2006, we had a total of $451.1 million in unfunded loan commitments and $73.2 million in unfunded standby letters of credit. Of the total unfunded loan commitments, $390.2 million were commitments available as lines of credit to be drawn at any time as customers’ cash needs vary, and $60.9 million were for loan commitments scheduled to close and become funded within the next twelve months. We monitor fluctuations in loan balances and commitment levels, and include such data in our overall liquidity management. The following table depicts our loan commitments at the end of the past three years. December 31, 2006 December 31, 2005 December 31, 2004 Commercial unused lines of credit Unused lines of credit secured by 1-4 family residential properties Credit card unused lines of credit Other consumer unused lines of credit Commitments to make loans Standby letters of credit Total $ 345,195,000 $ 303,115,000 $ 226,935,000 29,314,000 8,510,000 7,197,000 60,850,000 73,241,000 $ 524,307,000 27,830,000 7,971,000 10,791,000 83,280,000 59,058,000 $ 492,045,000 24,988,000 8,307,000 5,155,000 55,440,000 56,464,000 $ 377,289,000 MARKET RISK ANALYSIS Our primary market risk exposure is interest rate risk and, to a lesser extent, liquidity risk. All of our transactions are denominated in U.S. dollars with no specific foreign exchange exposure. We have only limited agricultural-related loan assets and therefore have no significant exposure to changes in commodity prices. Any impact that changes in foreign exchange rates and commodity prices would have on interest rates is assumed to be insignificant. Interest rate risk is the exposure of our financial condition to adverse movements in interest rates. We derive our income primarily from the excess of interest collected on interest-earning assets over the interest paid on interest-bearing liabilities. The rates of interest we earn on our assets and owe on our liabilities generally are established contractually for a period of time. Since market interest rates change over time, we are exposed to lower profitability if we cannot adapt to interest rate changes. Accepting interest rate risk can be an important source of profitability and shareholder value; however, excessive levels of interest rate risk could pose a significant threat to our earnings and capital base. Accordingly, effective risk management that maintains interest rate risk at prudent levels is essential to our safety and soundness. F-22 Evaluating the exposure to changes in interest rates includes assessing both the adequacy of the process used to control interest rate risk and the quantitative level of exposure. Our interest rate risk management process seeks to ensure that appropriate policies, procedures, management information systems and internal controls are in place to maintain interest rate risk at prudent levels with consistency and continuity. In evaluating the quantitative level of interest rate risk, we assess the existing and potential future effects of changes in interest rates on our financial condition, including capital adequacy, earnings, liquidity and asset quality. We use two interest rate risk measurement techniques. The first, which is commonly referred to as GAP analysis, measures the difference between the dollar amounts of interest-sensitive assets and liabilities that will be refinanced or repriced during a given time period. A significant repricing gap could result in a negative impact to the net interest margin during periods of changing market interest rates. The following table depicts our GAP position as of December 31, 2006 (dollars in thousands). Assets: Commercial loans (1) Leases Residential real estate loans Consumer loans Securities (2) Short term investments Allowance for loan and lease losses Other assets Total assets Liabilities: Interest-bearing checking Savings Money market accounts Time deposits under $100,000 Time deposits $100,000 and over Short term borrowings Federal Home Loan Bank advances Long term borrowings Noninterest-bearing checking Other liabilities Total liabilities Shareholders’ equity Total sources of funds Within Three Months Three to Twelve Months One to Five Years $ $ 893,234 11 60,235 3,169 8,711 282 0 0 965,642 39,943 92,370 9,409 34,550 351,745 95,272 30,000 36,306 0 0 689,595 0 689,595 60,125 22 4,597 134 2,478 0 0 0 67,356 0 0 0 53,196 587,818 0 50,000 0 0 0 691,014 0 691,014 $ 601,193 1,355 53,131 4,208 34,159 0 0 0 694,046 0 0 0 42,424 302,251 0 15,000 0 0 0 359,675 0 359,675 $ After Five Years 49,638 0 13,681 745 157,071 0 0 0 221,135 0 0 0 0 0 0 0 0 0 0 0 0 0 Total $ 1,604,190 1,388 131,644 8,256 202,419 282 (21,411) 140,500 2,067,268 39,943 92,370 9,409 130,170 1,241,814 95,272 95,000 36,306 133,197 21,872 1,895,353 171,915 2,067,268 Net asset (liability) GAP $ 276,047 $ (623,658) $ 334,371 $ 221,135 Cumulative GAP $ 276,047 $ (347,611) $ (13,240) $ 207,895 Percent of cumulative GAP to total assets 13.4% (16.8)% (0.6)% 10.1% (1) Floating rate loans that are currently at interest rate ceilings are treated as fixed rate loans and are reflected using maturity date and not repricing frequency. (2) Mortgage-backed securities are categorized by expected maturities based upon prepayment trends as of December 31, 2006. F-23 The following table depicts our GAP position as of December 31, 2005 (dollars in thousands). Assets: Commercial loans (1) Leases Residential real estate loans Consumer loans Securities (2) Short term investments Allowance for loan and lease losses Other assets Total assets Liabilities: Interest-bearing checking Savings Money market accounts Time deposits under $100,000 Time deposits $100,000 and over Short term borrowings Federal Home Loan Bank advances Long term borrowings Noninterest-bearing checking Other liabilities Total liabilities Shareholders’ equity Total sources of funds Within Three Months Three to Twelve Months One to Five Years $ $ 947,769 6 61,448 1,699 8,899 545 0 0 1,020,366 39,792 106,247 10,344 30,475 255,351 81,801 25,000 35,337 0 0 584,347 0 584,347 37,000 485 3,861 134 1,007 0 0 0 42,487 0 0 0 37,109 465,018 0 75,000 0 0 0 577,127 0 577,127 $ 408,931 1,295 49,302 3,011 32,095 0 0 0 494,634 0 0 0 36,370 317,818 0 30,000 0 0 0 384,188 0 384,188 $ After Five Years 32,832 0 13,500 539 139,613 0 0 0 186,484 0 0 0 0 0 0 0 0 0 0 0 0 0 Total $ 1,426,532 1,786 128,111 5,383 181,614 545 (20,527) 114,766 1,838,210 39,792 106,247 10,344 103,954 1,038,187 81,801 130,000 35,337 120,828 16,595 1,683,085 155,125 1,838,210 Net asset (liability) GAP $ 436,019 $ (534,640) $ 110,446 $ 186,484 Cumulative GAP $ 436,019 $ (98,621) $ 11,825 $ 198,309 Percent of cumulative GAP to total assets 23.7% (5.4)% 0.6% 10.8% (1) Floating rate loans that are currently at interest rate ceilings are treated as fixed rate loans and are reflected using maturity date and not repricing frequency. (2) Mortgage-backed securities are categorized by expected maturities based upon prepayment trends as of December 31, 2005. The second interest rate risk measurement used is commonly referred to as net interest income simulation analysis. We believe that this methodology provides a more accurate measurement of interest rate risk than the GAP analysis, and therefore, it serves as our primary interest rate risk measurement technique. The simulation model assesses the direction and magnitude of variations in net interest income resulting from potential changes in market interest rates. Key assumptions in the model include prepayment speeds on various loan and investment assets; cash flows and maturities of interest-sensitive assets and liabilities; and changes in market conditions impacting loan and deposit volume and pricing. These assumptions are inherently uncertain, subject to fluctuation and revision in a dynamic environment; therefore, the model cannot precisely estimate net interest income or exactly predict the impact of higher or lower interest rates on net interest income. Actual results will differ from simulated results due to timing, magnitude, and frequency of interest rate changes and changes in market conditions and our strategies, among other factors. F-24 We conducted multiple simulations as of December 31, 2006, in which it was assumed that changes in market interest rates occurred ranging from up 200 basis points to down 200 basis points in equal quarterly instalments over the next twelve months. The following table reflects the suggested impact on net interest income over the next twelve months, which is well within our policy parameters established to manage and monitor interest rate risk. Interest Rate Scenario Dollar Change In Net Interest Income Percent Change In Net Interest Income Interest rates down 200 basis points $ (2,776,000) (4.4)% Interest rates down 100 basis points No change in interest rates Interest rates up 100 basis points Interest rates up 200 basis points (2,064,000) (1,438,000) 569,000 2,552,000 (3.3) (2.3) 0.9 4.0 In addition to changes in interest rates, the level of future net interest income is also dependent on a number of other variables, including: the growth, composition and absolute levels of loans, deposits, and other earning assets and interest-bearing liabilities; economic and competitive conditions; potential changes in lending, investing, and deposit gathering strategies; client preferences; and other factors. F-25 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Board of Directors and Shareholders Mercantile Bank Corporation Grand Rapids, Michigan We have audited the accompanying consolidated balance sheets of Mercantile Bank Corporation as of December 31, 2006 and 2005, and the related consolidated statements of income, changes in shareholders' equity and cash flows for each of the three years in the period ended December 31, 2006. These financial statements are the responsibility of Mercantile’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Mercantile Bank Corporation as of December 31, 2006 and 2005, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2006 in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Mercantile Bank Corporation’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated February 20, 2007 expressed an unqualified opinion thereon. Grand Rapids, Michigan February 20, 2007 /s/ Crowe Chizek and Company LLC Crowe Chizek and Company LLC F-26 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Board of Directors and Shareholders Mercantile Bank Corporation Grand Rapids, Michigan We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that Mercantile Bank Corporation maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Mercantile Bank Corporation’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, management’s assessment that Mercantile Bank Corporation maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also in our opinion, Mercantile Bank Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements of Mercantile Bank Corporation and our report dated February 20, 2007 expressed an unqualified opinion on those consolidated financial statements. /s/ Crowe Chizek and Company LLC Crowe Chizek and Company LLC Grand Rapids, Michigan February 20, 2007 F-27 February 20, 2007 REPORT BY MERCANTILE BANK CORPORATION’S MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Management is responsible for establishing and maintaining an effective system of internal control over financial reporting presented in conformity with generally accepted accounting principles. There are inherent limitations in the effectiveness of any system of internal control. Accordingly, even an effective system of internal control can provide only reasonable assurance with respect to financial statement preparation. Management assessed the Company’s systems of internal control over financial reporting presented in conformity with generally accepted principles as of December 31, 2006. This assessment was based on criteria for effective internal control over financial reporting described in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, management believes that, as of December 31, 2006, Mercantile Bank Corporation maintained effective control over financial reporting presented in conformity with generally accepted accounting principles based on those criteria. The Company’s independent auditors have issued an audit report on our assessment of the Company’s internal control over financial reporting. Mercantile Bank Corporation /s/ Gerald R. Johnson, Jr. Gerald R. Johnson, Jr. Chairman and Chief Executive Officer /s/ Charles E. Christmas Charles E. Christmas Senior Vice President – Chief Financial Officer F-28 MERCANTILE BANK CORPORATION CONSOLIDATED BALANCE SHEETS December 31, 2006 and 2005 ASSETS Cash and due from banks Short term investments Total cash and cash equivalents Securities available for sale Securities held to maturity (fair value of $65,025,000 at December 31, 2006 and $62,850,000 at December 31, 2005) Federal Home Loan Bank stock Total loans and leases Allowance for loan and lease losses Total loans and leases, net Premises and equipment, net Bank owned life insurance policies Accrued interest receivable Other assets 2006 2005 $ 51,098,000 282,000 51,380,000 $ 36,208,000 545,000 36,753,000 130,967,000 112,961,000 63,943,000 7,509,000 60,766,000 7,887,000 1,745,478,000 (21,411,000) 1,724,067,000 1,561,812,000 (20,527,000) 1,541,285,000 33,539,000 30,858,000 10,287,000 14,718,000 30,206,000 28,071,000 8,274,000 12,007,000 Total assets $2,067,268,000 $1,838,210,000 LIABILITIES AND SHAREHOLDERS' EQUITY Deposits Noninterest-bearing Interest-bearing Total Securities sold under agreements to repurchase Federal funds purchased Federal Home Loan Bank advances Subordinated debentures Other borrowed money Accrued expenses and other liabilities Total liabilities Shareholders' equity Preferred stock, no par value; 1,000,000 shares authorized, none issued Common stock, no par value; 20,000,000 shares authorized; 8,022,221 and 7,590,526 shares issued and outstanding at December 31, 2006 and 2005 Retained earnings Accumulated other comprehensive income (loss) Total shareholders’ equity $ 133,197,000 1,513,706,000 1,646,903,000 $ 120,828,000 1,298,524,000 1,419,352,000 85,472,000 9,800,000 95,000,000 32,990,000 3,316,000 21,872,000 1,895,353,000 72,201,000 9,600,000 130,000,000 32,990,000 2,347,000 16,595,000 1,683,085,000 0 0 161,223,000 11,794,000 (1,102,000) 171,915,000 148,533,000 8,000,000 (1,408,000) 155,125,000 Total liabilities and shareholders’ equity $2,067,268,000 $1,838,210,000 See accompanying notes to consolidated financial statements. F-29 MERCANTILE BANK CORPORATION CONSOLIDATED STATEMENTS OF INCOME Years ended December 31, 2006, 2005 and 2004 Interest income Loans and leases, including fees Securities, taxable Securities, tax-exempt Federal funds sold Short-term investments Total interest income Interest expense Deposits Short-term borrowings Federal Home Loan Bank advances Long-term borrowings Total interest expense 2006 2005 2004 $ 127,470,000 6,557,000 2,739,000 482,000 12,000 137,260,000 $ 93,666,000 5,588,000 2,596,000 266,000 14,000 102,130,000 $ 62,791,000 3,935,000 2,217,000 75,000 4,000 69,022,000 64,755,000 2,867,000 5,393,000 2,658,000 75,673,000 38,884,000 1,795,000 4,200,000 1,959,000 46,838,000 21,786,000 877,000 2,471,000 1,461,000 26,595,000 Net interest income 61,587,000 55,292,000 42,427,000 Provision for loan and lease losses 5,775,000 3,790,000 4,674,000 Net interest income after provision for loan and lease losses 55,812,000 51,502,000 37,753,000 Noninterest income Service charges on accounts Increase in cash surrender value of bank owned life insurance policies Letter of credit fees Residential mortgage banking fees Gain on sale of commercial loans Gain on sale of securities Other income Total noninterest income Noninterest expense Salaries and benefits Occupancy Furniture and equipment Data processing Advertising Other expense Total noninterest expenses 1,386,000 1,391,000 1,255,000 1,165,000 443,000 553,000 29,000 0 1,685,000 5,261,000 18,983,000 3,136,000 2,050,000 1,657,000 600,000 5,836,000 32,262,000 997,000 422,000 634,000 84,000 0 2,133,000 5,661,000 18,635,000 2,641,000 1,667,000 1,186,000 554,000 6,434,000 31,117,000 735,000 450,000 440,000 225,000 78,000 1,119,000 4,302,000 13,956,000 1,588,000 1,093,000 880,000 465,000 5,216,000 23,198,000 Income before federal income tax expense 28,811,000 26,046,000 18,857,000 Federal income tax expense 8,964,000 8,145,000 5,136,000 Net income Earnings per share: Basic Diluted $ 19,847,000 $ 17,901,000 $ 13,721,000 $ 2.48 $ 2.45 $ 2.25 $ 2.20 $ 1.73 $ 1.69 See accompanying notes to consolidated financial statements. F-30 MERCANTILE BANK CORPORATION CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY Years ended December 31, 2006, 2005 and 2004 Balances, January 1, 2004 $ 118,560,000 $ 11,421,000 $ 220,000 $ 130,201,000 Common Stock Retained Earnings Accumulated Other Comprehensive Income/(Loss) Total Shareholders' Equity Payment of 5% stock dividend 12,111,000 (12,115,000) Employee stock purchase plan, 2,388 shares Dividend reinvestment plan, 3,754 shares Stock option exercises, 57,011 shares Stock tendered for stock option exercises, 12,058 shares 79,000 123,000 524,000 (387,000) Cash dividends ($0.34 per share) (2,552,000) (4,000) 79,000 123,000 524,000 (387,000) (2,552,000) Comprehensive income: Net income Change in net unrealized gain on securities available for sale, net of reclassifications and tax effect Total comprehensive income 13,721,000 13,721,000 (88,000) (88,000) 13,633,000 Balances, December 31, 2004 131,010,000 10,475,000 132,000 141,617,000 Payment of 5% stock dividend 17,187,000 (17,191,000) Employee stock purchase plan, 2,491 shares Dividend reinvestment plan, 4,099 shares Stock option exercises, 41,885 shares Stock tendered for stock option exercises, 8,043 shares 97,000 159,000 396,000 (316,000) Cash dividends ($0.41 per share) (3,185,000) (4,000) 97,000 159,000 396,000 (316,000) (3,185,000) Comprehensive income: Net income Change in net unrealized gain (loss) on securities available for sale, net of reclassifications and tax effect Total comprehensive income 17,901,000 17,901,000 (1,540,000) (1,540,000) 16,361,000 Balances, December 31, 2005 148,533,000 8,000,000 (1,408,000) 155,125,000 See accompanying notes to consolidated financial statements. F-31 MERCANTILE BANK CORPORATION CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (Continued) Years ended December 31, 2006, 2005 and 2004 Balances, December 31, 2005 $ 148,533,000 $ 8,000,000 $ (1,408,000) $ 155,125,000 Common Stock Retained Earnings Accumulated Other Comprehensive Income/(Loss) Total Shareholders' Equity Payment of 5% stock dividend 12,014,000 (12,018,000) Employee stock purchase plan, 2,774 shares Dividend reinvestment plan, 2,531 shares Stock option exercises, 61,897 shares Stock tendered for stock option exercises, 14,939 shares 107,000 98,000 814,000 (585,000) Cash dividends ($0.51 per share) (4,035,000) Equity compensation expense 242,000 (4,000) 107,000 98,000 814,000 (585,000) (4,035,000) 242,000 Comprehensive income: Net income Change in net unrealized loss on securities available for sale, net of reclassifications and tax effect Total comprehensive income 19,847,000 19,847,000 306,000 306,000 20,153,000 Balances, December 31, 2006 $ 161,223,000 $ 11,794,000 $ (1,102,000) $ 171,915,000 See accompanying notes to consolidated financial statements. F-32 MERCANTILE BANK CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS Years ended December 31, 2006, 2005 and 2004 Cash flows from operating activities Net income Adjustments to reconcile net income to net cash from operating activities Depreciation and amortization Provision for loan and lease losses Equity compensation expense Federal Home Loan Bank stock dividends Gain on sale of commercial loans Gain on sale of securities Earnings on bank owned life insurance policies Net change in Accrued interest receivable Other assets Accrued expenses and other liabilities Net cash from operating activities Cash flows from investing activities Purchases of: Securities available for sale Securities held to maturity Federal Home Loan Bank stock Proceeds from: Sales of securities available for sale Maturities, calls and repayments of securities available for sale Maturities, calls and repayments of securities held to maturity Redemption of Federal Home Loan Bank stock Loan originations and payments, net Purchases of premises and equipment, net Purchases of bank owned life insurance policies Net cash from investing activities Cash flows from financing activities Net increase in deposits Net increase in securities sold under agreements to repurchase Proceeds from Federal Home Loan Bank advances Pay-off of Federal Home Loan Bank advances Proceeds from issuance of subordinated debentures Pay-off of subordinated debentures Net increase (decrease) in other borrowed money Cash paid in lieu of fractional shares on stock dividend Employee stock purchase plan Dividend reinvestment plan Stock option exercises, net Cash dividends Net cash from financing activities 2006 2005 2004 $ 19,847,000 $ 17,901,000 $ 13,721,000 2,887,000 5,775,000 242,000 0 (29,000) 0 (1,166,000) (2,013,000) (1,068,000) 5,277,000 29,752,000 2,555,000 3,790,000 0 (146,000) (84,000) 0 (997,000) (2,630,000) (981,000) 7,190,000 26,598,000 1,699,000 4,674,000 0 (72,000) (225,000) (78,000) (735,000) (1,546,000) (1,478,000) 2,315,000 18,275,000 (24,886,000) (4,567,000) 0 (38,217,000) (10,065,000) (943,000) (54,718,000) (8,521,000) (1,749,000) 0 0 1,748,000 7,423,000 16,686,000 30,382,000 1,330,000 378,000 (190,657,000) (5,911,000) (1,621,000) (218,511,000) 1,586,000 0 (247,242,000) (7,677,000) (3,324,000) (289,196,000) 1,256,000 0 (282,170,000) (10,516,000) (6,574,000) (330,862,000) 227,551,000 260,171,000 256,289,000 13,271,000 80,000,000 (115,000,000) 0 0 1,169,000 (4,000) 107,000 98,000 229,000 (4,035,000) 203,386,000 15,884,000 75,000,000 (65,000,000) 0 0 (4,662,000) (4,000) 97,000 159,000 80,000 (3,185,000) 278,540,000 6,772,000 75,000,000 (45,000,000) 32,990,000 (16,495,000) 9,495,000 (4,000) 79,000 123,000 137,000 (2,552,000) 316,834,000 See accompanying notes to consolidated financial statements. F-33 MERCANTILE BANK CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued) Years ended December 31, 2006, 2005 and 2004 Net change in cash and cash equivalents Cash and cash equivalents at beginning of period Cash and cash equivalents at end of period Supplemental disclosures of cash flow information Cash paid during the year for Interest Federal income tax Transfers from loans and leases to foreclosed assets 2006 2005 2004 $ $ 14,627,000 36,753,000 51,380,000 67,925,000 10,875,000 2,129,000 $ $ 15,942,000 20,811,000 36,753,000 40,671,000 8,657,000 1,556,000 $ $ 4,247,000 16,564,000 20,811,000 25,107,000 6,125,000 0 See accompanying notes to consolidated financial statements. F-34 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2006 and 2005 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation: The consolidated financial statements include the accounts of Mercantile Bank Corporation (“Mercantile”) and its subsidiary, Mercantile Bank of Michigan (“Bank”), and of Mercantile Bank Mortgage Company, LLC (“Mortgage Company”), Mercantile Bank Real Estate Co., L.L.C. (“Mercantile Real Estate”) and Mercantile Insurance Center, Inc. (“Mercantile Insurance”), subsidiaries of our bank, after elimination of significant intercompany transactions and accounts. We formed a business trust, Mercantile Bank Capital Trust I (“the trust”), in 2004 to issue trust preferred securities. We issued subordinated debentures to the trust in return for the proceeds raised from the issuance of the trust preferred securities. In accordance with FASB Interpretation No. 46, the trust is not consolidated, but instead we report the subordinated debentures issued to the trust as a liability. Nature of Operations: Mercantile was incorporated on July 15, 1997 to establish and own the Bank based in Grand Rapids, Michigan. The Bank is a community-based financial institution. The Bank began operations on December 15, 1997. The Bank’s primary deposit products are checking, savings, and term certificate accounts, and its primary lending products are commercial loans, commercial leases, residential mortgage loans, and instalment loans. Substantially all loans and leases are secured by specific items of collateral including business assets, real estate or consumer assets. Commercial loans and leases are expected to be repaid from cash flow from operations of businesses. Real estate loans are secured by commercial or residential real estate. The Bank’s loan accounts are primarily with customers located in the Grand Rapids, Holland, Lansing and Ann Arbor metropolitan areas. The Bank’s retail deposits are also from customers located within those areas. As an alternative source of funds, the Bank has also issued certificates to depositors outside of the Bank’s primary market areas. Substantially all revenues are derived from banking products and services and investment securities. Mercantile Bank Mortgage Company was formed during 2000. A subsidiary of the Bank, Mercantile Bank Mortgage Company was established to increase the profitability and efficiency of the mortgage loan operations. Mercantile Bank Mortgage Company initiated business on October 24, 2000 via the Bank’s contribution of most of its residential mortgage loan portfolio and participation interests in certain commercial mortgage loans. On the same date, the Bank also transferred its residential mortgage origination function to Mercantile Bank Mortgage Company. On January 1, 2004, Mercantile Bank Mortgage Company was reorganized as Mercantile Bank Mortgage Company, LLC, a limited liability company, which is 99% owned by the Bank and 1% owned by Mercantile Insurance. Mortgage loans originated and held by the Mercantile Bank Mortgage Company are serviced by the Bank pursuant to a servicing agreement. Mercantile Insurance was formed during 2002 through the acquisition of an existing shelf insurance agency. Insurance products are offered through an Agency and Institutions Agreement among Mercantile Insurance, the Bank and Hub International. The insurance products are marketed through a central facility operated by the Michigan Bankers Insurance Association, members of which include the insurance subsidiaries of various Michigan-based financial institutions and Hub International. Mercantile Insurance receives commissions based upon written premiums produced under the Agency and Institutions Agreement. Mercantile Real Estate was organized on July 21, 2003, principally to develop, construct, and own a new facility in downtown Grand Rapids that serves as our bank’s main office and Mercantile’s headquarters. This facility was placed into service during the second quarter of 2005. Mercantile filed an election to become a financial holding company pursuant to Title I of the Gramm-Leach-Bliley Act and implementing Federal Reserve Board regulations effective March 23, 2000. (Continued) F-35 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2006 and 2005 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Use of Estimates: To prepare financial statements in conformity with accounting principles generally accepted in the United States of America, management makes estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided, and future results could differ. The allowance for loan and lease losses and the fair values of financial instruments are particularly subject to change. Cash Flow Reporting: Cash and cash equivalents include cash on hand, demand deposits with other financial institutions, short-term investments (including securities with daily put provisions) and federal funds sold. Cash flows are reported net for customer loan and deposit transactions, interest-bearing time deposits with other financial institutions and short-term borrowings with maturities of 90 days or less. Securities: Debt securities classified as held to maturity are carried at amortized cost when management has the positive intent and ability to hold them to maturity. Debt securities are classified as available for sale when they might be sold prior to maturity. Equity securities with readily determinable fair values are classified as available for sale. Securities available for sale are carried at fair value, with unrealized holding gains and losses reported in other comprehensive income, net of tax. Other securities such as Federal Home Loan Bank stock are carried at cost. Interest income includes amortization of purchase premiums and discounts. Premiums and discounts on securities are amortized on the level-yield method without anticipating prepayments, except for mortgage-backed securities where prepayments are anticipated. Gains and losses on sales are recorded on trade date and determined using the specific identification method. 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 cost, (2) the financial condition and near term prospects of the issuer, and (3) our ability and intent to hold the security for a period sufficient to allow for any anticipated recovery in fair value. Loans and Leases: Loans and leases that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the principal balance outstanding, net of unearned interest, deferred loan fees and costs and an allowance for loan and lease losses. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized in interest income using the level-yield method without anticipating prepayments. Interest income on commercial loans and leases and mortgage loans is discontinued at the time the loan is 90 days delinquent unless the loan is well-secured and in process of collection. Consumer and credit card loans are typically charged-off no later than 120 days past due. Past due status is based on the contractual terms of the loan or lease. In all cases, loans and leases are placed on nonaccrual or charged-off at an earlier date if collection of principal and interest is considered doubtful. All interest accrued but not received for loans and leases placed on nonaccrual is reversed against interest income. Interest received on such loans and leases is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans and leases are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured. Loans Held for Sale: Mortgage loans originated and intended for sale in the secondary market are carried at the lower of aggregate cost or market, as determined by outstanding commitments from investors. Net unrealized losses, if any, are recorded as a valuation allowance and charged to earnings. Such loans are sold service released. Residential mortgage banking fees include fees on direct brokered mortgage loans and the net gain on sale of mortgage loans originated for sale. (Continued) F-36 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2006 and 2005 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Allowance for Loan and Lease Losses: The allowance for loan and lease losses is a valuation allowance for probable incurred credit losses. Loan and lease losses are charged against the allowance when management believes the uncollectibility of a loan or lease balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. Management estimates the allowance balance required using past loan and lease loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, and economic conditions and other factors. Allocations of the allowance may be made for specific loans and leases, but the entire allowance is available for any loan or lease that, in management’s judgment, should be charged-off. A loan or lease is considered impaired when, based on current information and events, it is probable we will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan or lease and the borrower, including the length of delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis for commercial loans and leases and construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price or the fair value of collateral if the loan is collateral dependent. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. We do not separately identify individual residential and consumer loans for impairment disclosures. Transfers of Financial Assets: Transfers of financial assets are accounted for as sales when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when: (1) the assets have been isolated from the corporation, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the corporation does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity. Premises and Equipment: Land is carried at cost. Premises and equipment are stated at cost less accumulated depreciation. Buildings and related components are depreciated using the straight-line method with useful lives ranging from 5 to 33 years. Furniture, fixtures and equipment are depreciated using the straight-line method with useful lives ranging from 3 to 7 years. Maintenance, repairs and minor alterations are charged to current operations as expenditures occur and major improvements are capitalized. Long-term Assets: Premises and equipment and other long-term assets are reviewed for impairment when events indicate their carrying amount may not be recoverable from future undiscounted cash flows. If impaired, the assets are recorded at fair value. Foreclosed Assets: Assets acquired through or instead of foreclosure are initially recorded at fair value when acquired, establishing a new cost basis. If fair value declines, a valuation allowance is recorded through expense. Costs after acquisition are expensed. Bank Owned Life Insurance: The Bank has purchased life insurance policies on certain key officers. Bank owned life insurance is recorded at its cash surrender value, or the amount that can be realized. Repurchase Agreements: Substantially all repurchase agreement liabilities represent amounts advanced by various customers. Securities are pledged to cover these liabilities, which are not covered by federal deposit insurance. (Continued) F-37 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2006 and 2005 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Financial Instruments and Loan Commitments: Financial instruments include off-balance-sheet credit instruments, such as commitments to make loans and commercial letters of credit, issued to meet customer financing needs. The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded. Instruments, such as standby letters of credit that are considered financial guarantees in accordance with FASB Interpretation No. 45, are recorded at fair value. Stock Compensation: Statement of Financial Accounting Standards (“SFAS”) no. 123(R), Share-based Payment, using the modified prospective transition method, was adopted effective January 1, 2006. Accordingly, stock-based employee compensation cost was recorded starting in 2006 using the fair value method. For 2006, adopting this standard resulted in a reduction in net income before taxes and net income of $242,000 and a decrease in basic and diluted earnings per share of $0.03. Prior to January 1, 2006, employee compensation expense under stock options was reported using the intrinsic value method; therefore, no stock-based compensation cost is reflected in net income for the years ending December 31, 2005 and 2004, as all options granted had an exercise price equal to or greater than the market price of the underlying common stock at date of grant. The following table illustrates the effect on net income and earnings per share if expense was measured using the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, for the years ending December 31. Net income as reported Deduct: Stock-based compensation expense determined under fair value based method Pro forma net income Basic earnings per share as reported Pro forma basic earnings per share Diluted earnings per share as reported Pro forma diluted earnings per share 2005 2004 $ 17,901,000 $ 13,721,000 861,000 17,040,000 323,000 13,398,000 $ $ 2.25 2.14 2.20 2.09 $ $ 1.73 1.69 1.69 1.65 Income Taxes: Income tax expense is the total of the current year income tax due or refundable and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future tax amounts for the temporary differences between the carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized. Fair Values of Financial Instruments: Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed separately. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect the estimates. The fair value estimates of existing on- and off-balance sheet financial instruments do not include the value of anticipated future business or the values of assets and liabilities not considered financial instruments. (Continued) F-38 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2006 and 2005 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Earnings Per Share: Basic earnings per share is based on weighted average common shares outstanding during the period. Diluted earnings per share include the dilutive effect of additional potential common shares issuable under stock options. Earnings per share are restated for all stock dividends, including the 5% stock dividends paid on May 16, 2006, August 1, 2005 and May 3, 2004. The fair value of shares issued in stock dividends is transferred from retained earnings to common stock to the extent of available retained earnings. Comprehensive Income: Comprehensive income consists of net income and other comprehensive income. Other comprehensive income includes unrealized gains and losses on securities available for sale which are also recognized as separate components of equity. Contingencies: Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. We do not believe there now are such matters that would have a material effect on the financial statements. Reclassifications: Some items in the prior year financial statements were reclassified to conform to the current presentation. Operating Segments: While we monitor the revenue streams of the various products and services offered, the identifiable segments are not material and operations are managed and financial performance is evaluated on a company-wide basis. Accordingly, all of our financial service operations are aggregated in one reportable operating segment. Adoption of New Accounting Standards: In September 2006, the Securities and Exchange Commission (“SEC”) released Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB 108”), which is effective for fiscal years ending on or after November 15, 2006. SAB 108 provides guidance on how the effects of prior-year uncorrected financial statement misstatements should be considered in quantifying a current year misstatement. SAB 108 requires public companies to quantify misstatements using both an income statement (rollover) and balance sheet (iron curtain) approach and evaluate whether either approach results in a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. If prior year errors that had been previously considered immaterial now are considered material based on either approach, no restatement is required so long as management properly applied its previous approach and all relevant facts and circumstances were considered. Adjustments considered immaterial in prior years under the method previously used, but now considered material under the dual approach required by SAB 108, are to be recorded upon initial adoption of SAB 108. The amount so recorded, if any, is shown as a cumulative effect adjustment recorded in opening retained earnings as of January 1, 2006. The adoption of SAB 108 had no effect on the financial statements for the year ending December 31, 2006. In July 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109 (“FIN 48”), which prescribes a recognition threshold and measurement attribute for a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. We have determined that the adoption of FIN 48 will not have a material effect on the financial statements. (Continued) F-39 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2006 and 2005 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Effect of Newly Issued But Not Yet Effective Accounting Standards: New accounting standards have been issued that we do not expect will have a material effect on the financial statements when adopted in future years or for which we have not yet completed its evaluation of the potential effect upon adoption. In general, these standards revise accounting for derivatives embedded in other financial instruments for 2007, revise the recognition and accounting for servicing of financial assets for 2007, establish a hierarchy about the assumptions used to measure fair value for 2008, revise the accrual of post-retirement benefits associated with providing life insurance for 2008 and revise the accounting for cash surrender value for 2007. NOTE 2 – SECURITIES The fair value of available for sale securities and the related gross unrealized gains and losses recognized in accumulated other comprehensive income (loss) were as follows: 2006 U.S. Government agency debt obligations Mortgage-backed securities Mutual fund 2005 U.S. Government agency debt obligations Mortgage-backed securities Mutual fund Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Fair Value $ 77,544,000 54,039,000 1,080,000 $ 197,000 80,000 0 $ (905,000) (1,036,000) (32,000) $ 76,836,000 53,083,000 1,048,000 $ 132,663,000 $ 277,000 $ (1,973,000) $ 130,967,000 $ 64,665,000 49,426,000 1,035,000 $ 15,000 39,000 0 $ (968,000) (1,228,000) (23,000) $ 63,712,000 48,237,000 1,012,000 $ 115,126,000 $ 54,000 $ (2,219,000) $ 112,961,000 The carrying amount, unrecognized gains and losses, and fair value of securities held to maturity were as follows: 2006 Municipal general obligation bonds Municipal revenue bonds 2005 Municipal general obligation bonds Municipal revenue bonds Carrying Amount Gross Gross Unrecognized Unrecognized Gains Losses Fair Value $ 56,870,000 7,073,000 $ 1,098,000 198,000 $ (197,000) (17,000) $ 57,771,000 7,254,000 $ 63,943,000 $ 1,296,000 $ (214,000) $ 65,025,000 $ 53,685,000 7,081,000 $ 1,859,000 339,000 $ (101,000) (13,000) $ 55,443,000 7,407,000 $ 60,766,000 $ 2,198,000 $ (114,000) $ 62,850,000 (Continued) F-40 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2006 and 2005 NOTE 2 – SECURITIES (Continued) Securities with unrealized losses at year-end 2006 and 2005, aggregated by investment category and length of time that individual securities have been in a continuous loss position are as follows: Description of Securities 2006 U.S. Government agency debt obligations Mortgage-backed securities Mutual fund Municipal general obligation bonds Municipal revenue bonds 2005 U.S. Government agency debt obligations Mortgage-backed securities Mutual fund Municipal general obligation bonds Municipal revenue bonds Less than 12 Months Fair Value Unrealized Loss 12 Months or More Fair Value Unrealized Loss Total Fair Value Unrealized Loss $ 1,971,000 $ 1,831,000 0 (9,000) $53,939,000 $ (896,000) (1,024,000) (32,000) 40,784,000 1,048,000 (12,000) 0 $55,910,000 $ (905,000) 42,615,000 (1,036,000) (32,000) 1,048,000 9,097,000 620,000 (90,000) (3,000) 7,771,000 718,000 (107,000) (14,000) 16,868,000 (197,000) (17,000) 1,338,000 $13,519,000 $ (114,000) $104,260,000 $ (2,073,000) $117,779,000 $(2,187,000) $51,082,000 $ (705,000) $ 5,735,000 $ (263,000) (479,000) 32,794,000 0 1,012,000 13,284,000 0 (749,000) (23,000) $56,817,000 $ (968,000) 46,078,000 (1,228,000) (23,000) 1,012,000 7,156,000 0 (65,000) 0 1,565,000 723,000 (36,000) (13,000) 8,721,000 (101,000) (13,000) 723,000 $92,044,000 $ (1,542,000) $21,307,000 $ (791,000) $113,351,000 $(2,333,000) We evaluate securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. Consideration is given to the length of time and the extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and the intent and ability we have to retain our investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. In analyzing an issuer’s financial condition, we may consider whether the securities are issued by the federal government or its agencies, whether downgrades by bond rating agencies have occurred and the results of reviews of the issuer’s financial condition. At December 31, 2006, $117.7 million in debt securities and a mutual fund have unrealized losses with aggregate depreciation of 1.1% from the amortized cost basis of total securities. After we considered whether the securities were issued by the federal government or its agencies and whether downgrades by bond rating agencies had occurred, we determined that unrealized losses were due to an increasing interest rate environment. As we have the ability to hold debt securities until maturity, or for the foreseeable future if classified as available for sale, no declines are deemed to be other than temporary. (Continued) F-41 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2006 and 2005 NOTE 2 – SECURITIES (Continued) The amortized cost and fair values of debt securities at year-end 2006, by contractual maturity, are shown below. The contractual maturity is utilized below for U.S. Government agency debt obligations and municipal bonds. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Securities not due at a single maturity date, primarily mortgage backed securities, are shown separately. The maturities of securities and their weighted average yields at December 31, 2006 are shown in the following table. The yields for municipal securities are shown at their tax equivalent yield. ---------------- Held-to-Maturity ---------------- -------------Available-for-Sale -------------- Weighted Average Yield Weighted Average Amortized Carrying Amount Fair Value Fair Value Yield Cost Due in one year or less Due from one to five years Due from five to ten years Due after ten years Mortgage-backed Mutual fund 7.11% $ 2,593,000 8,798,000 6.87 11,533,000 6.38 41,019,000 6.39 0 NA 0 NA $ 2,606,000 9,060,000 11,789,000 41,570,000 0 0 $ NA 0 4.72% 17,864,000 59,680,000 5.21 NA 0 54,039,000 5.03 1,080,000 4.36 $ 0 17,647,000 59,189,000 0 53,083,000 1,048,000 6.48% $ 63,943,000 $ 65,025,000 5.06% $132,663,000 $130,967,000 During 2006 and 2005, there were no securities sold. During 2004, securities with an aggregate amortized cost basis of $1.7 million were sold, resulting in a gross realized gain of $78,000. At year-end 2006 and 2005, the amortized cost of securities issued by the state of Michigan and all its political subdivisions totaled $63.9 million and $60.8 million, with an estimated market value of $65.0 million and $62.9 million, respectively. Total securities of any other specific issuer, other than the U.S. Government and its agencies, did not exceed 10% of shareholders’ equity. The carrying value of securities that are pledged to repurchase agreements and other deposits was $92.2 million and $81.7 million at December 31, 2006 and 2005, respectively. (Continued) F-42 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2006 and 2005 NOTE 3 – LOANS AND LEASES AND ALLOWANCE FOR LOAN AND LEASE LOSSES Year-end loans and leases are as follows: December 31, 2006 Balance % December 31, 2005 Balance % Percent Increase/ (Decrease) Real Estate: Construction and land development Secured by 1 – 4 family properties Secured by multi- family properties Secured by nonresidential properties Commercial Leases Consumer $ 293,656,000 16.8% $ 226,544,000 14.5% 29.6% 131,644,000 31,003,000 7.5 1.8 128,111,000 30,114,000 8.2 2.0 808,259,000 471,272,000 1,388,000 8,256,000 46.3 27.0 0.1 0.5 714,963,000 454,911,000 1,786,000 5,383,000 45.8 29.1 0.1 0.3 2.8 3.0 13.0 3.6 (22.3) 53.4 $1,745,478,000 100.0% $1,561,812,000 100.0% 11.8% Activity in the allowance for loan and lease losses is as follows: Beginning balance Provision for loan and lease losses Charge-offs Recoveries 2006 2005 2004 $ 20,527,000 5,775,000 (5,389,000) 498,000 $ 17,819,000 3,790,000 (1,392,000) 310,000 $ 14,379,000 4,674,000 (1,405,000) 171,000 Ending balance $ 21,411,000 $ 20,527,000 $ 17,819,000 Impaired loans and leases were as follows: Year-end loans with no allocated allowance for loan and lease losses Year-end loans with allocated allowance for loan and lease losses Amount of the allowance for loan and lease losses allocated Average of impaired loans during the year 2006 2005 $ $ $ 558,000 3,999,000 4,557,000 1,149,000 6,142,000 $ $ $ 1,390,000 965,000 2,355,000 399,000 2,460,000 The Bank recognized no interest income on impaired loans during 2006, 2005 or 2004. Nonperforming loans includes both smaller balance homogenous loans that are collectively evaluated for impairment and individually classified impaired loans. (Continued) F-43 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2006 and 2005 NOTE 3 – LOANS AND LEASES AND ALLOWANCE FOR LOAN AND LEASE LOSSES (Continued) Nonperforming loans and leases were as follows: 2006 2005 Loans and leases past due over 90 days still accruing interest Nonaccrual loans and leases $ 819,000 7,752,000 $ 394,000 3,601,000 $ 8,571,000 $ 3,995,000 Concentrations within the loan portfolio were as follows at year-end: 2 0 0 6 2 0 0 5 Balance Percentage of Loan Portfolio Balance Percentage of Loan Portfolio Commercial real estate loans to lessors of non-residential buildings $ 471,222,000 27.0% $ 417,470,000 26.7% NOTE 4 - PREMISES AND EQUIPMENT, NET Year-end premises and equipment are as follows: Land and improvements Buildings and leasehold improvements Furniture and equipment Less: accumulated depreciation 2006 2005 $ 8,021,000 23,036,000 10,773,000 41,830,000 8,291,000 $ 7,135,000 18,450,000 10,351,000 35,936,000 5,730,000 $ 33,539,000 $ 30,206,000 Depreciation expense in 2006, 2005 and 2004 totaled $2,578,000, $2,043,000 and $1,248,000, respectively. We entered into lease arrangements for our banking facilities in East Lansing and Ann Arbor, Michigan during 2005. Rent expense for these two facilities totaled $276,000 and $144,000 during 2006 and 2005, respectively. Minimum rent commitments under the operating leases were as follows, before considering renewal options that generally are present: 2007 2008 2009 2010 Total $ 207,000 160,000 164,000 83,000 $ 614,000 (Continued) F-44 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2006 and 2005 NOTE 5 – DEPOSITS Deposits at year-end are summarized as follows: Noninterest-bearing demand Interest-bearing checking Money market Savings Time, under $100,000 Time, $100,000 and over Out-of-area time, under $100,000 Out-of-area time, $100,000 and over December 31, 2006 Balance % December 31, 2005 Balance % Percent Increase/ (Decrease) $ 133,197,000 8.1% $ 120,828,000 8.5% 10.2% 39,943,000 9,409,000 92,370,000 47,840,000 310,326,000 633,085,000 82,330,000 931,488,000 1,013,818,000 2.4 0.6 5.6 2.9 18.8 38.4 5.0 56.6 61.6 39,792,000 10,344,000 106,247,000 23,906,000 2.8 0.7 7.5 1.7 155,401,000 456,518,000 11.0 32.2 80,048,000 5.6 882,786,000 962,834,000 62.2 67.8 0.4 (9.0) (13.1) 100.1 99.7 38.7 2.9 5.5 5.3 $1,646,903,000 100.0% $1,419,352,000 100.0% 16.0% Out-of-area certificates of deposit consist of certificates obtained from depositors outside of the primary market area. As of December 31, 2006, out-of-area certificates of deposit totaling $987.0 million were obtained through deposit brokers, with the remaining $26.8 million obtained directly from the depositors. The following table depicts the maturity distribution for certificates of deposit at year-end. In one year or less In one to two years In two to three years In three to four years In four to five years 2006 2005 $1,027,309,000 258,692,000 54,988,000 11,111,000 19,884,000 $ 787,954,000 243,652,000 68,467,000 33,649,000 8,419,000 $1,371,984,000 $1,142,141,000 The following table depicts the maturity distribution for certificates of deposit with balances of $100,000 or more at year-end. Up to three months Three months to six months Six months to twelve months Over twelve months 2006 2005 $ 351,745,000 246,357,000 341,461,000 302,251,000 $ 255,351,000 186,830,000 278,189,000 317,817,000 $1,241,814,000 $1,038,187,000 (Continued) F-45 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2006 and 2005 NOTE 6 – SHORT-TERM BORROWINGS Information regarding securities sold under agreements to repurchase, at year-end is summarized below: Outstanding balance at year-end Weighted average interest rate at year-end Average daily balance during the year Weighted average interest rate during the year Maximum month end balance during the year 2006 2005 $ 85,472,000 3.88% 72,228,000 3.71% 85,472,000 $ 72,201,000 3.31% 60,743,000 2.63% 74,639,000 Securities sold under agreements to repurchase (repurchase agreements) generally have original maturities of less than one year. Repurchase agreements are treated as financings and the obligations to repurchase securities sold are reflected as liabilities. Securities involved with the repurchase agreements are recorded as assets of the Bank and are primarily held in safekeeping by correspondent banks. Repurchase agreements are offered principally to certain large deposit customers as uninsured deposit equivalent investments. Repurchase agreements were secured by securities with a market value of $91.2 million and $80.7 million at year-end 2006 and 2005, respectively. NOTE 7 - FEDERAL HOME LOAN BANK ADVANCES At year-end, advances from the Federal Home Loan Bank were as follows. 2006 2005 Maturities January 2007 through May 2008, fixed rates from 3.70% to 5.69%, averaging 4.90% $ 95,000,000 Maturities January 2006 through May 2008, fixed rates from 2.13% to 4.92%, averaging 3.68% Maturities in May 2006, floating rates tied to Libor indices, averaging 4.42% $ 120,000,000 10,000,000 $ 95,000,000 $ 130,000,000 Each advance is payable at its maturity date, and is subject to a prepayment fee if paid prior to the maturity date. The 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 the Bank, under a blanket lien arrangement. Our borrowing line of credit as of December 31, 2006 totaled $322.6 million. Maturities over the next five years are: 2007 2008 2009 2010 2011 $ 80,000,000 15,000,000 0 0 0 (Continued) F-46 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2006 and 2005 NOTE 8 - FEDERAL INCOME TAXES The consolidated provision for income taxes is as follows: Current Deferred benefit Tax expense 2006 2005 2004 $ 9,438,000 (474,000) $ 9,124,000 (979,000) $ 5,981,000 (845,000) $ 8,964,000 $ 8,145,000 $ 5,136,000 Income tax expense was less than the amount computed by applying the statutory federal income tax rate to income before income taxes. The reasons for the difference are as follows: Statutory rates Increase (decrease) from Tax-exempt interest Life insurance Rehabilitation tax credits Other 2006 2005 2004 $ 10,084,000 $ 9,116,000 $ 6,600,000 (795,000) (408,000) 0 83,000 (792,000) (349,000) 0 170,000 (708,000) (257,000) (429,000) (70,000) Tax expense $ 8,964,000 $ 8,145,000 $ 5,136,000 The net deferred tax asset recorded includes the following amounts of deferred tax assets and liabilities: Deferred tax assets Allowance for loan and lease losses Unrealized loss on securities available for sale Deferred loan fees Deferred compensation Other Deferred tax liabilities Depreciation Other $ 2006 2005 7,494,000 594,000 231,000 1,181,000 234,000 9,734,000 1,052,000 525,000 1,577,000 $ 7,184,000 758,000 307,000 821,000 239,000 9,309,000 947,000 515,000 1,462,000 Net deferred tax asset $ 8,157,000 $ 7,847,000 A valuation allowance related to deferred tax assets is required when it is considered more likely than not that all or part of the benefits related to such assets will not be realized. Management has determined that no valuation allowance was required at year-end 2006 or 2005. (Continued) F-47 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2006 and 2005 NOTE 9 – STOCK-BASED COMPENSATION Stock-based compensation plans are used to provide directors and employees with an increased incentive to contribute to the long-term performance and growth of Mercantile, to join the interests of directors and employees with the interests of Mercantile’s shareholders through the opportunity for increased stock ownership and to attract and retain directors and employees. From 1997 through 2005, stock option grants were provided to directors and certain employees through several stock option plans, including the 1997 Employee Stock Option Plan, 2000 Employee Stock Option Plan, 2004 Employee Stock Option Plan and Independent Director Stock Option Plan. During 2006, stock option and restricted stock grants were provided to certain employees through the Stock Incentive Plan of 2006. Under our 1997 Employee Stock Option Plan, 2000 Employee Stock Option Plan and 2004 Employee Stock Option Plan, stock options granted to employees were granted at the market price on the date of grant, generally fully vest after one year and expire ten years from the date of grant. Stock options granted to non-executive officers during 2005 vested about three weeks after being granted. Under our Independent Director Stock Option Plan, stock options granted to non-employee directors are at 125% of the market price on the date of grant, fully vest after five years and expire ten years from the date of grant. The Stock Incentive Plan of 2006, approved by our shareholders at the annual meeting on April 27, 2006, replaced all of our outstanding stock option plans for stock options not previously granted. Under the Stock Incentive Plan of 2006, incentive awards may include, but are not limited to, stock options, restricted stock, stock appreciation rights and stock awards. Incentive awards that are stock options or stock appreciation rights are granted with an exercise price not less than the closing price of Mercantile stock on the day before the date of grant, with price, vesting and expiration date parameters determined by Mercantile’s Compensation Committee on a grant-by-grant basis. Generally, the stock options granted to employees during 2006 fully vest after two years and expire after seven years. The restricted stock awards granted to certain employees during 2006, totaling 20,190 shares and having a fair value per share of $39.84, fully vest after four years. No payments were required from employees for the restricted stock awards. At year-end 2006, there were 550,884 shares authorized for future incentive awards. As of December 31, 2006, there was $300,000 of total unrecognized compensation cost related to unvested stock options granted under our various stock-based compensation plans. The compensation cost is expected to be recognized over a weighted-average period of 1.5 years. As of December 31, 2006, there was $690,000 of total unrecognized compensation cost related to unvested restricted stock granted under our Stock Incentive Plan of 2006. The compensation cost is expected to be recognized over a period of 3.9 years. A summary of stock option activity is as follows. 2006 2005 2004 Weighted Average Price Shares Weighted Average Price Shares Weighted Average Price Shares 314,830 24,640 (61,897) (2,204) $ 21.81 39.84 13.14 33.55 310,495 47,540 (41,885) (1,320) $ 17.77 37.68 9.45 35.36 321,203 46,303 (57,011) 0 $ 13.56 36.43 9.19 0.00 275,369 $ 25.28 314,830 $ 21.81 310,495 $ 17.77 Outstanding at beginning of year Granted Exercised Forfeited or expired Outstanding at end of year Options exercisable at year-end 223,505 $ 22.63 269,700 $ 20.17 241,658 $ 13.62 (Continued) F-48 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2006 and 2005 NOTE 9 – STOCK-BASED COMPENSATION (Continued) The fair value of each stock option award is estimated on the date of grant using a closed option valuation (Black- Scholes) model that uses the assumptions noted in the table below. Expected volatilities are based on historical volatilities on our common stock. Historical data is used to estimate stock option expense and post-vesting termination behavior. The expected term of stock options granted is based on historical data and represents the period of time that stock options granted are expected to be outstanding, which takes into account that the stock options are not transferable. The risk-free interest rate for the expected term of the stock option is based on the U.S. Treasury yield curve in effect at the time of the stock option grant. The fair value of stock options granted was determined using the following weighted-average assumptions as of grant date. Risk-free interest rate Expected option life Expected stock price volatility Dividend yield 2006 2005 2004 4.60% 5 Years 26% 1% 4.12% 7 Years 26% 1% 3.45% 7 Years 22% 1% Options outstanding at year-end 2006 were as follows: Outstanding Exercisable Range of Exercise Prices $ 4.00 - $ 8.00 $ 8.01 - $12.00 $12.01 - $16.00 $16.01 - $20.00 $20.01 - $24.00 $24.01 - $28.00 $32.01 - $36.00 $36.01 - $40.00 $40.01 - $44.00 Weighted Average Weighted Average Exercise Price Remaining Contractual Life Number 8,952 42,208 29,306 37,907 7,272 30,592 41,783 70,186 7,163 0.6 Years 3.0 Years 4.8 Years 5.6 Years 5.8 Years 6.8 Years 7.7 Years 8.2 Years 7.8 Years $ 7.46 9.20 13.07 16.84 21.19 27.94 35.29 38.44 42.29 Weighted Average Exercise Price $ 7.46 9.20 13.07 16.84 NA 27.94 35.36 37.68 NA Number 8,952 42,208 29,306 37,907 0 30,592 34,847 39,693 0 Outstanding at year end 275,369 6.1 Years $ 25.28 223,505 $ 22.63 The weighted-average remaining contractual life of the 223,505 stock options exercisable as of December 31, 2006 was 5.8 years. Options outstanding at year-end 2006, 2005 and 2004 were as follows: Minimum exercise price Maximum exercise price Average remaining option term 2006 2005 2004 $ 7.46 42.29 6.1 Years $ 7.46 42.29 6.5 Years $ 7.46 42.29 6.5 Years (Continued) F-49 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2006 and 2005 NOTE 9 – STOCK-BASED COMPENSATION (Continued) Information related to stock option grants and exercises during 2006, 2005 and 2004 follows: 2006 2005 2004 Intrinsic value of stock options exercised Cash received from stock option exercises Tax benefit realized from stock option exercises Weighted average fair value of stock options granted $1,616,000 229,000 0 11.44 $1,243,000 80,000 0 13.51 $1,310,000 137,000 0 9.82 The aggregate intrinsic value of all stock options outstanding at December 31, 2006 was $3,507,000. The aggregate intrinsic value of all stock options exercisable at December 31, 2006 was $3,367,000. Shares issued as a result of the exercise of stock option grants are new shares as provided for under our stock-based compensation plans. NOTE 10 – RELATED PARTIES Certain directors and executive officers of the Bank, including their immediate families and companies in which they are principal owners, were loan customers of the Bank. At year-end 2006 and 2005, the Bank had $18.3 million and $14.0 million in loan commitments to directors and executive officers, of which $8.8 million and $8.9 million were outstanding at year-end 2006 and 2005, respectively, as reflected in the following table. Beginning balance New loans Repayments Ending balance 2006 2005 $ 8,865,000 2,356,000 (2,424,000) $ 10,210,000 761,000 (2,106,000) $ 8,797,000 $ 8,865,000 Related party deposits and repurchase agreements totaled $15.7 million and $13.3 million at year-end 2006 and 2005, respectively. NOTE 11 – COMMITMENTS AND OFF-BALANCE-SHEET RISK We are a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments include commitments to extend credit and standby letters of credit. Loan commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. (Continued) F-50 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2006 and 2005 NOTE 11 – COMMITMENTS AND OFF-BALANCE-SHEET RISK (Continued) These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized, if any, in the balance sheet. Our maximum exposure to loan loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments. We use the same credit policies in making commitments and conditional obligations as we do for on-balance sheet instruments. Collateral, such as accounts receivable, securities, inventory, property and equipment, is generally obtained based on management’s credit assessment of the borrower. If required, estimated loss exposure resulting from these instruments is expensed and recorded as a liability. The balance of the liability account related to loan commitments was $0.5 million at year-end 2006 and 2005. At year-end 2006 and 2005, the rates on existing off-balance sheet instruments were substantially equivalent to current market rates, considering the underlying credit standing of the counterparties. Our maximum exposure to credit losses for loan commitments and standby letters of credit outstanding at year-end was as follows: Commercial unused lines of credit Unused lines of credit secured by 1 – 4 family residential properties Credit card unused lines of credit Other consumer unused lines of credit Commitments to make loans Standby letters of credit 2006 2005 $ 345,195,000 $ 303,115,000 29,314,000 8,510,000 7,197,000 60,850,000 73,241,000 27,830,000 7,971,000 10,791,000 83,280,000 59,058,000 $ 524,307,000 $ 492,045,000 Commitments to make loans generally reflect our binding obligations to existing and prospective customers to extend credit, including line of credit facilities secured by accounts receivable and inventory, and term debt secured by either real estate or equipment. In most instances, line of credit facilities are for a one year term and are at a floating rate tied to the prime rate. For term debt secured by real estate, customers are generally offered a floating rate tied to the prime rate and a fixed rate currently ranging from 7.25% to 8.25%. These credit facilities generally balloon within five years, with payments based on amortizations ranging from 10 to 25 years. For term debt secured by non-real estate collateral, customers are generally offered a floating rate tied to the prime rate and a fixed rate currently ranging from 7.25% to 8.25%. These credit facilities generally mature and fully amortize within five years. The following instruments are considered financial guarantees under FASB Interpretation 45. These instruments are carried at fair value. 2 0 0 6 2 0 0 5 Contract Amount Carrying Value Contract Amount Carrying Value Standby letters of credit $ 73,241,000 $ 279,000 $ 59,058,000 $ 205,000 We were required to have $8.9 million and $8.6 million of cash on hand or on deposit with the Federal Reserve Bank of Chicago to meet regulatory reserve and clearing requirements at year-end 2006 and 2005, respectively. These balances do not earn interest. (Continued) F-51 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2006 and 2005 NOTE 12 – BENEFIT PLANS We have a 401(k) benefit plan that covers substantially all of our employees. Our 2006, 2005 and 2004 matching 401(k) contribution charged to expense was $674,000, $554,000 and $413,000, respectively. The percent of our matching contributions to the 401(k) is determined annually by the Board of Directors. The 401(k) benefit plan allows employee contributions up to 15% of their compensation, which are matched at 100% of the first 5% of the compensation contributed. Matching contributions are immediately vested. We have a deferred compensation plan in which all persons serving on the Board of Directors may defer all or portions of their annual retainer and meeting fees, with distributions to be paid only upon termination of service as a director. The deferred amounts are categorized on our financial statements as other borrowed money. The deferred balances are paid interest at a rate equal to the prime rate, adjusted at the beginning of each calendar quarter. Interest expense for the plan during 2006, 2005 and 2004 was $81,000, $43,000 and $21,000, respectively. We have a non-qualified deferred compensation program in which selected officers may defer all or portions of salary and bonus payments. The deferred amounts are categorized on our financial statements as other borrowed money. The deferred balances are paid interest at a rate equal to the prime rate, adjusted at the beginning of each calendar quarter. Interest expense for the plan during 2006, 2005 and 2004 was $148,000, $79,000 and $38,000, respectively. The Mercantile Bank Corporation Employee Stock Purchase Plan of 2002 (“Stock Purchase Plan”) is a non- compensatory plan intended to encourage full- and part-time employees of Mercantile and its subsidiaries to promote our best interests and to align employees’ interests with the interests of our shareholders by permitting employees to purchase shares of our common stock through regular payroll deductions. Shares are purchased on the last business day of each calendar quarter at a price equal to the average, rounded to the nearest whole cent, of the highest and lowest sales prices of our common stock reported on The Nasdaq Stock Market. Originally, 25,000 shares of common stock may be issued under the Stock Purchase Plan; however, the number of shares has been and may continue to be adjusted in the future to reflect stock dividends and other changes in our capitalization. The numbers of shares issued under the Stock Purchase Plan totaled 2,774 and 2,491 in 2006 and 2005, respectively. As of December 31, 2006, there were 20,820 shares available under the Stock Purchase Plan. (Continued) F-52 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2006 and 2005 NOTE 13 - FAIR VALUES OF FINANCIAL INSTRUMENTS Carrying amount and estimated fair values of financial instruments were as follows at year-end. 2 0 0 6 2 0 0 5 Carrying Values Fair Values Carrying Values Fair Values Financial assets Cash and cash equivalents Securities available for sale Securities held to maturity Federal Home Loan Bank stock Loans, net Bank owned life insurance policies Accrued interest receivable $ 51,380,000 130,967,000 63,943,000 7,509,000 1,724,067,000 30,858,000 10,287,000 $ 51,380,000 130,967,000 65,025,000 7,509,000 1,707,039,000 30,858,000 10,287,000 $ 36,753,000 112,961,000 60,766,000 7,887,000 1,541,285,000 28,071,000 8,274,000 $ 36,753,000 112,961,000 62,850,000 7,887,000 1,540,183,000 28,071,000 8,274,000 Financial liabilities Deposits Securities sold under agreements to repurchase Federal funds purchased Federal Home Loan Bank advances Accrued interest payable Subordinated debentures 1,646,903,000 1,654,798,000 1,419,352,000 1,425,606,000 85,472,000 9,800,000 95,000,000 20,213,000 32,990,000 85,472,000 9,800,000 94,801,000 20,213,000 32,984,000 72,201,000 9,600,000 130,000,000 12,465,000 32,990,000 72,201,000 9,600,000 129,942,000 12,465,000 32,990,000 Carrying amount is the estimated fair value for cash and cash equivalents, Federal Home Loan Bank stock, accrued interest receivable and payable, bank owned life insurance policies, demand deposits, securities sold under agreements to repurchase, and variable rate loans or deposits that reprice frequently and fully. Security fair values are based on market prices or dealer quotes, and if no such information is available, on the rate and term of the security and information about the issuer. For fixed rate loans or deposits and for variable rate loans or deposits with infrequent repricing or repricing limits, fair value is based on discounted cash flows using current market rates applied to the estimated life and credit risk. Fair value of subordinated debentures and Federal Home Loan Bank advances is based on current rates for similar financing. Fair value of off balance sheet items is estimated to be nominal. (Continued) F-53 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2006 and 2005 NOTE 14 – EARNINGS PER SHARE The factors used in the earnings per share computation follow. Basic Net income 2006 2005 2004 $ 19,847,000 $ 17,901,000 $ 13,721,000 Weighted average common shares outstanding 8,003,013 7,959,338 7,909,687 Basic earnings per common share $ 2.48 $ 2.25 $ 1.73 Diluted Net income $ 19,847,000 $ 17,901,000 $ 13,721,000 Weighted average common shares outstanding for basic earnings per common share 8,003,013 7,959,338 7,909,687 Add: Dilutive effects of assumed exercises of stock options Average shares and dilutive potential common shares 109,342 177,826 198,110 8,112,355 8,137,163 8,107,797 Diluted earnings per common share $ 2.45 $ 2.20 $ 1.69 Stock options for 10,268, 7,166 and 50,767 shares of common stock were not considered in computing diluted earnings per common share for 2006, 2005 and 2004, respectively, because they were antidilutive. NOTE 15 – SUBORDINATED DEBENTURES Mercantile Trust, a business trust formed by the company, was incorporated in 2004 for the purpose of issuing Series A and Series B Preferred Securities. On September 16, 2004, Mercantile Trust sold the Series A Preferred Securities in a private sale for $16.0 million, and also sold $495,000 of Series A Common Securities to Mercantile. The proceeds of the Series A Preferred Securities and the Series A Common Securities were used by Mercantile Trust to purchase $16,495,000 of Series A Floating Rate Notes that were issued by Mercantile on September 16, 2004. Mercantile used the proceeds of the Series A Floating Rate Notes to finance the redemption on September 17, 2004 of the $16.0 million of 9.60% Cumulative Preferred Securities issued in 1999 by MBWM Capital Trust I. On December 10, 2004, Mercantile Trust sold the Series B Preferred Securities in a private sale for $16.0 million, and also sold $495,000 of Series B Common Securities to Mercantile. The proceeds of the Series B Preferred Securities and the Series B Common Securities were used by Mercantile Trust to purchase $16,495,000 of Series B Floating Rate Notes that were issued by Mercantile on December 10, 2004. Substantially all of the net proceeds of the Series B Floating Rate Notes were contributed to our bank as capital to provide support for asset growth, fund investments in loans and securities and for general corporate purposes. The only significant assets of Mercantile Trust are the Series A and Series B Floating Rate Notes, and the only significant liabilities of Mercantile Trust are the Series A and Series B Preferred Securities. The Series A and Series B Floating Rate Notes are categorized on our consolidated balance sheet as subordinated debentures and the interest expense is recorded on our consolidated statement of income under interest expense on long-term borrowings. (Continued) F-54 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2006 and 2005 NOTE 16 - REGULATORY MATTERS Mercantile and the Bank are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and prompt corrective action regulations involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weightings, and other factors, and the regulators can lower classifications in certain cases. Failure to meet various capital requirements can initiate regulatory action that could have a direct material effect on the financial statements. The prompt corrective action regulations provide five classifications, including well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, although these terms are not used to represent overall financial condition. If an institution is adequately capitalized, regulatory approval is required to accept brokered deposits. Subject to limited exceptions, no institution may make a capital distribution if, after making the distribution, it would be undercapitalized. If an institution is undercapitalized, it is subject to being closely monitored by its principal federal regulator, its asset growth and expansion are restricted, and plans for capital restoration are required. In addition, further specific types of restrictions may be imposed on the institution in the discretion of the federal regulator. At year-end 2006 and 2005, the most recent regulatory notifications categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that we believe has changed the Bank’s category. At year end, actual capital levels (in thousands) and minimum required levels for Mercantile and the Bank were: Actual Amount Ratio Minimum Required for Capital Adequacy Purposes Ratio Amount Minimum Required to be Well Capitalized Under Prompt Corrective Action Regulations Ratio Amount $ 226,428 222,812 11.5% 11.3 $ 158,196 158,019 8.0% 8.0 $ NA 197,524 NA 10.0% 205,017 201,401 10.4 10.2 205,017 201,401 10.0 9.9 79,098 79,010 81,682 81,623 4.0 4.0 4.0 4.0 NA 118,514 NA 6.0 NA 102,029 NA 5.0 2006 Total capital (to risk weighted assets) Consolidated Bank Tier 1 capital (to risk weighted assets) Consolidated Bank Tier 1 capital (to average assets) Consolidated Bank (Continued) F-55 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2006 and 2005 NOTE 16 - REGULATORY MATTERS (Continued) Actual Amount Ratio Minimum Required for Capital Adequacy Purposes Ratio Amount Minimum Required to be Well Capitalized Under Prompt Corrective Action Regulations Ratio Amount 2005 Total capital (to risk weighted assets) Consolidated Bank Tier 1 capital (to risk weighted assets) Consolidated Bank Tier 1 capital (to average assets) Consolidated Bank $ 209,060 205,642 12.0% 11.8 $ 139,337 139,158 8.0% 8.0 $ NA 173,947 NA 10.0% 188,533 185,115 10.8 10.6 188,533 185,115 10.5 10.3 69,669 69,579 72,163 72,100 4.0 4.0 4.0 4.0 NA 104,368 NA 6.0 NA 90,124 NA 5.0 Federal and state banking laws and regulations place certain restrictions on the amount of dividends the Bank can transfer to Mercantile and on the capital levels that must be maintained. At year-end 2006, under the most restrictive of these regulations (to remain well capitalized), the Bank could distribute approximately $22.5 million to Mercantile as dividends without prior regulatory approval. The capital levels as of year-end 2006 and 2005 include $32.0 million of trust preferred securities issued by Mercantile Trust in September 2004 and December 2004 subject to certain limitations. Federal Reserve guidelines limit the amount of trust preferred securities which can be included in Tier 1 capital of Mercantile to 25% of total Tier 1 capital. At year-end 2006 and 2005, all $32.0 million of the trust preferred securities were included as Tier 1 capital of Mercantile. NOTE 17 - OTHER COMPREHENSIVE INCOME/(LOSS) Other comprehensive income/(loss) components and related taxes were as follows. Unrealized holding gains and losses on available-for-sale securities Reclassification adjustments for gains and losses later recognized in income Net unrealized gains and losses Tax effect of unrealized holding gains and losses on available-for-sale securities Tax effect of reclassification adjustments for gains and losses later recognized in income 2006 2005 2004 $ 470,000 $ (2,368,000) $ (208,000) 0 470,000 0 (2,368,000) (78,000) (130,000) (164,000) 828,000 70,000 0 0 (28,000) Other comprehensive income/(loss) $ 306,000 $ (1,540,000) $ (88,000) (Continued) F-56 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2006 and 2005 NOTE 18 - QUARTERLY FINANCIAL DATA (UNAUDITED) Interest Income Net Interest Income Net Income Earnings per Share Basic Fully Diluted 2006 First quarter Second quarter Third quarter Fourth quarter 2005 First quarter Second quarter Third quarter Fourth quarter 2004 First quarter Second quarter Third quarter Fourth quarter $ 31,099,000 33,746,000 35,675,000 36,740,000 $15,099,000 15,646,000 15,547,000 15,295,000 $ 4,929,000 5,111,000 5,202,000 4,605,000 $ 0.62 0.64 0.65 0.57 $ 21,705,000 24,346,000 26,764,000 29,315,000 $12,655,000 13,608,000 14,072,000 14,957,000 $ 4,362,000 4,690,000 4,300,000 4,549,000 $ 0.58 0.62 0.57 0.60 $ 15,354,000 16,130,000 17,819,000 19,719,000 $ 9,489,000 10,000,000 10,856,000 12,082,000 $ 2,973,000 3,146,000 3,114,000 4,488,000 $ 0.40 0.42 0.41 0.59 $ 0.61 0.63 0.64 0.57 $ 0.56 0.61 0.56 0.59 $ 0.39 0.41 0.40 0.58 NOTE 19 – MERCANTILE BANK CORPORATION (PARENT COMPANY ONLY) CONDENSED FINANCIAL STATEMENTS Following are condensed parent company only financial statements. CONDENSED BALANCE SHEETS ASSETS Cash and cash equivalents Investment in bank subsidiary Other assets Total assets LIABILITIES AND SHAREHOLDERS’ EQUITY Liabilities Subordinated debentures Shareholders’ equity 2006 2005 $ 2,323,000 200,300,000 2,890,000 $ 2,045,000 183,707,000 2,898,000 $ 205,513,000 $ 188,650,000 $ 608,000 32,990,000 171,915,000 $ 535,000 32,990,000 155,125,000 Total liabilities and shareholders’ equity $ 205,513,000 $ 188,650,000 (Continued) F-57 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2006 and 2005 NOTE 19 – MERCANTILE BANK CORPORATION (PARENT COMPANY ONLY) CONDENSED FINANCIAL STATEMENTS (Continued) CONDENSED STATEMENTS OF INCOME Income Dividends from subsidiaries Other Total income Expenses Interest expense Other operating expenses Total expenses 2006 2005 2004 $ 6,440,000 73,000 6,513,000 $ 4,832,000 46,000 4,878,000 $ 4,032,000 25,000 4,057,000 2,429,000 1,917,000 4,346,000 1,837,000 942,000 2,779,000 1,402,000 1,666,000 3,068,000 Income before income tax benefit and equity in undistributed net income of subsidiary 2,167,000 2,099,000 989,000 Federal income tax benefit (1,392,000) (936,000) (1,051,000) Equity in undistributed net income of subsidiary 16,288,000 14,866,000 11,681,000 Net income $ 19,847,000 $ 17,901,000 $ 13,721,000 (Continued) F-58 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2006 and 2005 NOTE 19 – MERCANTILE BANK CORPORATION (PARENT COMPANY ONLY) CONDENSED FINANCIAL STATEMENTS (Continued) CONDENSED STATEMENT OF CASH FLOWS Cash flows from operating activities Net income Adjustments to reconcile net income to net cash from operating activities Equity in undistributed income of subsidiary Equity compensation expense Change in other assets Change in other liabilities Net cash from operating activities Cash flows from investing activities Net capital investment into subsidiaries Net cash from investing activities Cash flows from financing activities Proceeds from the issuance of subordinated debentures Pay-off of subordinated debentures Stock option exercises, net Employee stock purchase plan Dividend reinvestment plan Cash dividends Fractional shares paid Net cash from financing activities 2006 2005 2004 $ 19,847,000 $ 17,901,000 $ 13,721,000 (16,288,000) 242,000 9,000 73,000 3,883,000 (14,866,000) 0 (98,000) 317,000 3,254,000 (11,681,000) 0 553,000 (140,000) 2,453,000 0 0 0 0 (16,495,000) (16,495,000) 0 0 229,000 107,000 98,000 (4,035,000) (4,000) (3,605,000) 0 0 80,000 97,000 159,000 (3,185,000) (4,000) (2,853,000) 32,990,000 (16,495,000) 137,000 79,000 123,000 (2,552,000) (4,000) 14,278,000 Net change in cash and cash equivalents 278,000 401,000 236,000 Cash and cash equivalents at beginning of period 2,045,000 1,644,000 1,408,000 Cash and cash equivalents at end of period $ 2,323,000 $ 2,045,000 $ 1,644,000 F-59 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on February 22, 2007. MERCANTILE BANK CORPORATION /s/ Gerald R. Johnson, Jr. Gerald R. Johnson, Jr. Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on February 22, 2007. /s/ Betty S. Burton Betty S. Burton, Director /s/ David M. Cassard David M. Cassard, Director /s/ Edward J. Clark Edward J. Clark, Director /s/ Peter A. Cordes Peter A. Cordes, Director /s/ C. John Gill C. John Gill, Director /s/ Doyle A. Hayes Doyle A. Hayes, Director /s/ David M. Hecht David M. Hecht, Director /s/ Susan K. Jones Susan K. Jones, Director /s/ Lawrence W. Larsen Lawrence W. Larsen, Director /s/ Calvin D. Murdock Calvin D. Murdock, Director /s/ Michael H. Price Michael H. Price, Director, President and Chief Operating Officer /s/ Merle J. Prins Merle J. Prins, Director /s/ Dale J. Visser Dale J. Visser, Director /s/ Donald Williams, Sr. Donald Williams, Sr., Director /s/ Gerald R. Johnson, Jr. Gerald R. Johnson, Jr., Chairman of the Board and Chief Executive Officer (principal executive officer) /s/ Charles E. Christmas Charles E. Christmas, Senior Vice President, Chief Financial Officer and Treasurer (principal financial and accounting officer) 43495MercantileBlank 2/23/07 8:49 AM Page 1 THIS PAGE LEFT INTENTIONALLY BLANK 43495MercantileInfo 2/27/07 9:14 AM Page 1 Corporate Information DIRECTORS AND EXECUTIVE OFFICERS OFFICERS Mercantile Bank of Michigan Amy M. Derry Assistant Branch Manager (Knapps), Officer Betty S. Burton Retired Educator and Business Owner Sonali D. Allen Vice President, Community Development Officer Kevin R. DeVries Vice President, IT Director David M. Cassard President, Waters Corporation Kathleen M. Arbanas Loan Administration Team Leader, Officer Charles E. Christmas Senior Vice President, CFO & Treasurer, Mercantile Bank Corporation Mark S. Augustyn Senior Vice President, Commercial Lender Edward J. Clark Chairman & CEO, American Seating Company Peter A. Cordes President & CEO, GWI Engineering, Inc. C. John Gill Retired Executive, Gill Industries Doyle A. Hayes President & CEO, Pyper Products Corporation David M. Hecht Attorney Gerald R. Johnson, Jr. Chairman & CEO, Mercantile Bank Corporation Susan K. Jones Owner, Susan K. Jones & Associates; Professor, Ferris State University; Partner, The Callahan Group LLC Robert B. Kaminski, Jr. Executive Vice President and Secretary, Mercantile Bank Corporation Lawrence W. Larsen President & CEO, Central Industrial Supply Company; President & CEO, Jet Products, Inc. Calvin D. Murdock President, SF Supply, Inc. Michael H. Price President & COO, Mercantile Bank Corporation Merle J. Prins Retired Bank Executive Andrew M. Baker Mortgage Lender, Officer Stacie L. Bakke Assistant Special Services Manager, Officer Andrew D. Bellingar Vice President, Commercial Lender (Lansing) Beatrice M. Berghorst Assistant Branch Manager (Holland), Officer Ramon Berlanga Assistant Vice President, Commercial Lender Keane A. Blaszczynski Vice President, Commercial Lender Jenny J. Bloem Assistant Vice President, Assistant Controller Curtis J. Bobeldyk Vice President, Business Development Officer (Holland) Jeffery P. Brown Item Processing Manager, Officer Walter G. Byers Senior Vice President, Washtenaw City President John E. Byl Vice President, Treasury Sales Manager Sherri A. Calcut Senior Vice President, Retail Loan Department Head Joseph S. Calvaruso Senior Vice President, Director of Risk Management Cathleen A. Calveneau Vice President, Branch Manager (Knapps) Dale J.Visser Chairman, Visser Brothers, Inc. Charles E. Christmas Senior Vice President & CFO Donald Williams, Sr. Dean Emeritus, Grand Valley State University Kimberly A. Christmas Vice President, Branch Manager (Alpine) Rose M. Constantine Assistant Vice President, Mortgage Lender Carolyn J. DeNeut Executive Assistant, Officer Harold L. Drenten Senior Vice President, Business Development Officer Raymond A. Duimstra Vice President, Commercial Lender Kyle B. Erickson Vice President, Commercial Lender (Holland) Marianne Essing Assistant Vice President, Deposit/Proof Operations Supervisor Melissa L. Fairchild Loan Production Specialist (Holland), Officer Douglas R. Fisher Broker, Officer Thomas L. Fitzgerald Senior Vice President, Credit Administrator Ralph E. Gady Assistant Vice President, Payroll Manager Kent G. Gagnon Vice President, Business Development Officer Daren L. Gantz Vice President, Accounting Manager Lawrence A. Gass Vice President, Business Development Officer (Washtenaw) Thomas M. Gotelaere Assistant Vice President, Mortgage Lender (Washtenaw) Bryan J. Gras Vice President, Commercial Lender (Holland) Terri L. Gray Vice President, Retail Lender Maurice H. Groce Assistant Vice President, Business Development Officer Elizabeth J. Gromko Assistant Vice President, Treasury Sales Specialist Dennis K. Grounds Vice President, Commercial Lender (Lansing) C. Howard Haas Senior Vice President, Lansing City President Bart J. Hamlin Vice President, Commercial Lender Jennifer S. Harris Assistant Payroll Manager, Officer 43495MercantileInfo 2/27/07 9:14 AM Page 2 Beth A. Harrison Executive Assistant (Holland), Officer Justin M. Karl Commercial Loan Portfolio Manager, Officer Michael H. Price President & CEO Eric S. Haynes Commercial Loan Portfolio Manager, Officer Jennifer A. Kastelic Loan Review Specialist, Officer Cassanda A. Puskala Assistant Branch Manager (Lansing), Officer Adrienne S. Heidema Internal Audit Team Leader, Officer Thomas J. Kelly Senior Vice President, Commercial Lender Thomas Q. Hoban Senior Vice President, Commercial Lender (Lansing) Sarah M. Hodgkins Vice President, Systems Support Manager Mark R. Hoffhines Senior Vice President, Commercial Lender Susan L. Hoffman Assistant Vice President, Mortgage Operations Supervisor Gregory G. Holt Real Estate Valuation Risk Manager, Officer Douglas J. Holtrop Assistant Vice President, Commercial Loan Portfolio Manager Brett E. Hoover Vice President, Human Resource Administrator Christine L. Hugmeyer Vice President, Branch Manager (Wyoming) Joy A. Hulst Vice President, Mortgage Lender Brenda K. Ingersoll Assistant Vice President, Commercial Operations Supervisor Sandy K. Jager Vice President, Internal Auditor Christine G. Johnson Vice President, Commercial Lender (Washtenaw) Gerald R. Johnson, Jr. Chairman Mildred L. Johnson Assistant Vice President, Funds Manager Jeffrey R. Kaiser Vice President, Loan Review Manager Amy W. Kam Executive Assistant, Officer Robert B. Kaminski, Jr. Executive Vice President, COO & Secretary Matthew L. Kind Loan Review Specialist, Officer Derrick J. Kooistra Assistant Vice President, Operations Project Manager Jason M. Kooistra Assistant Vice President, Broker Jason H. Kovick Assistant Vice President, Branch Manager (Lansing) Michael R. Kroft Vice President, Electronic Banking Services Manager Kyle P. Kunnen Vice President, Operations Manager Mary B. Libby Vice President, Mortgage Manager (Holland) Wanda Martinez Assistant Vice President, Assistant Branch Manager (Wyoming) Raymond E. Reitsma Senior Vice President, Commercial Loan Manager Deborah A. Rogers Senior Vice President, Business Development Officer Jason R. Ross Retail Lender, Officer Sandra M. Ross Vice President, Branch Manager (Washtenaw) Claire L. Rotman Assistant Vice President, Branch Manager (Holland) Melanie S. Salamone Vice President, Branch Manager (Kentwood) Michael J. Sankey Vice President, Controller Kevin M. Schafer Assistant Vice President, Commercial Credit Manager Lori A. Schafer Mortgage Loan Processing Supervisor, Officer Danna A. Mathiesen Assistant Vice President, Retail Lender Donald K. Schneider Vice President, Retail Lender Kathleen M. Mauric Assistant Vice President, Wire Transfer Manager Katherine B. McHenry Assistant Vice President, Commercial Lender Gretchen A. Murphy Vice President, Training Director Robert M. Nicey Vice President, Commercial Lender Theodore A. Schork Senior Vice President, Commercial Lender (Washtenaw) John R. Schulte Senior Vice President, Chief Information Officer Suzanne C. Schultz Senior Loan Administrative Assistant, Officer (Washtenaw) Jodi L. Nowicki-Domanski Assistant Vice President, Risk Management Scott P. Setlock Assistant Commercial Credit Manager, Officer Gordon L. Oosting Senior Vice President, Commercial Lender John R. Shaw Mortgage Lender, Officer (Lansing) John E. Ormstad Electronic Banking Assistant Manager, Officer Michael F. Siminski II Vice President, Commercial Lender Gary L. Palmitier Vice President, Commercial Lender (Holland) Lindsay A. Spitler Assistant Vice President, Commercial Lender Daniel A. Poskey Assistant Branch Manager (Leonard), Officer Kevin M. Stacey Senior Vice President, Loan Review Department Head 43495MercantileInfo 2/27/07 9:14 AM Page 3 Cheri L. Stanton Vice President, Branch Manager (Leonard) OFFICERS Mercantile Bank Mortgage Company, LLC Jonathan P. Steiner Senior Vice President, Holland City President Mark S. Augustyn Senior Vice President, Commercial Lender Tara M. Strickler Branch Operations Manager, Officer Andrew M. Baker Mortgage Lender, Officer David A. Struck Loan Review Specialist, Officer Andrew M. Bellingar Vice President, Commercial Lender (Lansing) Sherri A. Calcut President, Mortgage Company Rose M. Constantine Assistant Vice President, Mortgage Lender Kyle B. Erickson Vice President, Commercial Lender (Holland) Melissa L. Fairchild Loan Production Specialist (Holland), Officer Thomas M. Gotelaere Assistant Vice President, Mortgage Lender (Washtenaw) Dennis K. Grounds Vice President, Commercial Lender (Lansing) Susan L. Hoffman Assistant Vice President, Mortgage Operations Supervisor Joy A. Hulst Vice President, Mortgage Lender Mary B. Libby Vice President, Mortgage Manager (Holland) Danna A. Mathiesen Assistant Vice President, Retail Lender Jason R. Ross Retail Lender, Officer Lori A. Schafer Mortgage Loan Processing Supervisor, Officer Donald K. Schneider Vice President, Retail Lender John R. Shaw Mortgage Lender, Officer (Lansing) Jessica L.Webster Assistant Vice President, Commercial Lender H. Joann Yates Assistant Vice President, Mortgage Lender Katie L. Stygstra Broker Assistant, Officer Jason A.Taber Assistant Vice President, Loan Operations Manager Julie R.VanDyke Loan Administrative Assistant Team Leader (Holland), Officer Tina L. Van Valkenburg Assistant Vice President, Human Resource Specialist Matthew J.Venema Commercial Loan Portfolio Manager, Officer Audrey J.Versluis Assistant Vice President, Special Services Manager Jessica L.Webster Assistant Vice President, Commercial Lender Michael F. Webster Vice President, Commercial Lender Paul R.Wegener Assistant Vice President, Loss Prevention & Security Manager Lonna L.Wiersma Senior Vice President, Human Resource Director Catherine A.Williams Branch Operations Assistant Manager, Officer Kyle E.Wilson Assistant Vice President, Commercial Lender H. Joann Yates Assistant Vice President, Mortgage Lender William H.Young Senior Vice President, Commercial Lender John R. Zimmerman Vice President, Marketing/Corporate Communications Manager Matthew J. Zimmerman Vice President, Commercial Lender Laurie A. Zurek Vice President, Retail Lender SHAREHOLDER INFORMATION Annual Meeting The Corporation’s Annual Meeting of Shareholders will be held on Thursday, April 26, 2007, at Cascade Hills Country Club, 3725 Cascade Road SE, Grand Rapids MI 49546 at 9:00 a.m. EST. Administrative Headquarters 310 Leonard Street NW, 4th Floor Grand Rapids MI 49504 616.406.3000 Legal Counsel Dickinson Wright PLLC 500 Woodward Avenue Suite 4000 Detroit MI 48226-3425 Independent Certified Public Accountants Crowe Chizek and Company LLP 55 Campau Avenue NW Grand Rapids MI 49503 Investor Relations Margolin & Associates, Inc. 2575 Bolton Road Cleveland Heights OH 44118 Common Stock Listing Nasdaq Global Select Market Symbol: MBWM Stock Registrar and Transfer Agent Computershare PO Box 43023 Providence RI 02940-3023 1.877.282.1168 www.computershare.com SEC Form 10-K Copies of the Corporation’s Annual Report on Form 10-K, as filed with the Securities and Exchange Commission, are available to shareholders without charge upon written request. Please mail your request to: Charles E. Christmas, Mercantile Bank Corporation, 310 Leonard Street NW, 4th Floor, Grand Rapids, MI 49504. Mercantile Bank Corporation does not discriminate on the basis of race, color, national origin, sex, religion, age or disability in employment or the provision of services. 43495MercantileInfo 2/27/07 9:14 AM Page 4 Mission Statement The mission of Mercantile Bank of Michigan is to provide financial products and services in a highly professional and personalized manner. We recognize that our most important partners are our customers. We will satisfy our customers by delivering top quality service that distinguishes us from our competitors. Our employees are our most valuable asset. We strive to hire exceptional team members and are committed to maintaining an environment of growth and development. We recognize the importance of being strong supporters of the diverse communities we serve, and pledge our commitment to making them stronger. We believe that fulfilling our mission to our customers, employees and community will allow us to reward our shareholders with an excellent return on their investment in Mercantile Bank. 43495MercantileBlank 2/23/07 8:49 AM Page 1 THIS PAGE LEFT INTENTIONALLY BLANK Mercantile Bank Corporation Board of Directors Back row (L-R): Ed Clark, Susan Jones, Larry Larsen, Jerry Johnson, Mike Price, Cal Murdock, Betty Burton, Dale Visser, Doyle Hayes, Merle Prins, Pete Cordes. Front row (L-R): John Gill, Dave Cassard, David Hecht, Don Williams. Quality, Not Quantity “To a lot of banks, service is simply having a branch on every corner,” says Mike Sankey. “It has nothing to Mike Sankey Controller Grand Rapids do with the customer experience inside those branches.” Mercantile has a limited number of branches, so the emphasis is on the quality of the customer interaction. “We don’t have to hire anybody that comes along just to fill our buildings. We take our time to get the very best people. Then we empower them to do whatever it takes to ® please customers.” ® 310 Leonard Street NW Grand Rapids MI 49504 888.345.6296 www.mercbank.com 002CS-13283
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