While most analysts are focusing on First Merchants Corporation's stabilizing net interest margin and loan growth expectations, a closer look at the FRME Q1 2024 earnings call transcript reveals a potentially explosive opportunity hiding in plain sight: a strategically positioned mortgage business poised to capitalize on any future interest rate declines.

First, let's address the elephant in the room – the much-anticipated rate cuts. While the exact timing and magnitude remain uncertain, the current consensus leans towards rate cuts in the back half of 2024. First Merchants, with its asset-sensitive balance sheet, is expected to see a slight margin compression with each cut – approximately 3 basis points for every 25-basis point reduction, according to CFO Michele Kawiecki. However, this seemingly negative impact on margin could be more than offset by an often overlooked factor: a surge in mortgage business.

During the earnings call, Kawiecki noted that a declining rate environment typically "invigorates" the bank's mortgage business, leading to higher gain on sale of mortgage loans. This statement, though brief, carries significant implications. While the bank's mortgage business saw a seasonal low in Q1 2024, the underlying performance is actually quite robust.

Here's where it gets interesting. Despite the seasonal dip, Q1 2024 gains on mortgage loan sales were significantly higher compared to the same period last year – $3.7 million (excluding a one-time loss on the sale of non-accrual loans) versus $2.4 million in Q1 2023. This year-over-year growth, a whopping 54%, underscores the potential of First Merchants' mortgage business in a declining rate environment.

Hypothesis:

Given the strategic enhancements made to the mortgage business since the Level One acquisition, coupled with the robust underlying performance in Q1 2024, First Merchants has the potential to significantly surpass its historical mortgage income levels when rate cuts materialize.

Let's break down the logic. First, the Level One acquisition effectively doubled First Merchant's mortgage origination capabilities, as highlighted by CEO Mark Hardwick. Second, the 54% year-over-year gain growth in Q1 2024, despite the seasonal low, suggests a robust underlying performance and increased efficiency within the mortgage business.

"...we were encouraged by this quarter's activity because the $3.3 million of gains this quarter included a $500,000 loss on the sale of some non-accrual loans. Excluding that loss, gains on the sales of mortgage loans would have been $3.7 million, which is a $1.3 million increase over the first quarter of last year. This increase in year-over-year production is what gives us confidence that we will see an increase in non-interest income in the coming quarters. - Michele Kawiecki, CFO"

Potential Impact of Rate Cuts

This leads us to a crucial question: what if First Merchants, with its enhanced mortgage business, could achieve a 25% increase over its historical mortgage income levels in a declining rate environment? The implications for earnings and shareholder value are compelling. A 25% increase over the $20 million baseline would translate to $25 million in annual mortgage loan gain sales – an additional $5 million in annual pre-tax income.

While this hypothetical scenario is dependent on the timing and magnitude of rate cuts, the potential upside is undeniable. First Merchants, with its strategically positioned mortgage business, is not just a story of stabilizing margins and loan growth; it's a story of a potential mortgage goldmine waiting to be unearthed.

"Fun Fact: The term "basis point" is often used in finance. A basis point is one hundredth of one percent, so a 25-basis point reduction would equal a 0.25% decrease in interest rates."