10-K 1 merc10k.htm BODY OF FORM 10-K


 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

FORM 10-K

 

(Mark One)

[X]

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended

December 31, 2007

 


 

or

 

[  ]

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from

 

to

 
 


 


   

Commission file number

0-11595

 


 

MERCHANTS BANCSHARES, INC.

(Exact name of registrant as specified in its charter)

 

Delaware

 

03-0287342

(State or OtherJurisdiction of
Incorporation or Organization)

 

(I.R.S. Employer
Identification No.)

     

275 Kennedy Drive, South Burlington, Vermont

 

05403

(Address of principal executive offices)

 

(Zip Code)

 

Registrant's telephone number, including area code

(802) 658-3400

 

Securities registered pursuant to Section 12(b) of the Act:

 

Title of each class

Name of each exchange on which registered

Common Stock, par value $.01 per share

NASDAQ

 

Securities registered pursuant to Section 12(g) of the Act:

 

None

 


 

(Title of class)

 

Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

[  ] Yes   [X] No

 

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   [X] No

 

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.

[X] Yes [  ] No

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K ([SECTION] 229.405 of this chapter) is not contained herein, and will not be contained, to the best of 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 nonaccelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Large Accelerated Filer [  ]

Accelerated Filer [X]

Nonaccelerated Filer [  ]

 

Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act).

[  ] Yes   [X] No

 

The aggregate market value of the registrant's voting common stock held by non-affiliates was $90,663,450 as computed using the per share price, as reported on the NASDAQ, as of market close June 30, 2007.

 

The number of shares outstanding for each of the registrant's classes of common stock, as of February 29, 2008, is:

Class: Common stock, par value $.01 per share, outstanding: 5,777,306 shares

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the Proxy Statement to Shareholders for the Registrant's Annual Meeting of Shareholders to be held on May 6, 2008 are incorporated herein by reference to Part III.

 


<PAGE>

MERCHANTS BANCSHARES, INC. AND SUBSIDIARIES
2007 FORM 10-K ANNUAL REPORT

 

TABLE OF CONTENTS

 

Part I

Page Reference


Item 1 -

Business

4 - 11

Item 1A -

Risk Factors

11 - 12

Iterm 1B -

Unresolved Staff Comments

12

Item 2 -

Properties

12

Item 3 -

Legal Proceedings

12

Item 4 -

Submission of Matters to a Vote of Security Holders

12

Part II


Item 5 -

Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities


13 - 15

Item 6 -

Selected Financial Data

15 - 17

Item 7 -

Management's Discussion and Analysis of Financial Condition and Results of Operations


18 - 36

Item 7A -

Quantitative and Qualitative Disclosures about Market Risk

36 - 40

Item 8 -

Financial Statements and Supplementary Data

41 - 70

Item 9 -

Changes in and Disagreements with Accountants on Accounting and Financial Disclosures


74

Item 9A -

Controls and Procedures

74

Item 9B -

Other Information

74

Part III


Item 10 -

Directors, Executive Officers and Corporate Governance

74

Item 11 -

Executive Compensation

74

Item 12 -

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters


74

Item 13 -

Certain Relationships and Related Transactions, and Director Independence

74

Item 14 -

Principal Accountant Fees and Services

74

Part IV **


Item 15 -

Exhibits and Financial Statement Schedules

75 - 77

Signatures

78

*

The information required by Part III is incorporated herein by reference from Merchants' Proxy Statement for the Annual Meeting of Shareholders to be held on May 6, 2008, including specifically the Nominating & Governance Committee report to be included therein.

**

A list of exhibits to the Form 10-K is set forth on the Exhibit Index included in the Form 10-K filed with the SEC. Copies of any exhibit to the Form 10-K may be obtained from Merchants by contacting Investor Relations, Merchants Bancshares, Inc., P.O. Box 1009, Burlington, VT 05402-1009. All financial statement schedules are omitted since the required information is included in the consolidated financial statements of the Company and notes thereto in the Form 10-K.

<PAGE>  2

FORWARD-LOOKING STATEMENTS

 

Except for the historical information contained herein, this Annual Report on Form 10-K of Merchants may contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 (the "Exchange Act"). Investors are cautioned that forward-looking statements are inherently uncertain. Actual performance and results of operations may differ materially from those projected or suggested in the forward-looking statements due to certain risks and uncertainties, including, without limitation:

 

(i)

the fact that Merchants' success is generally dependent upon global and national economic conditions, and particularly economic conditions in Vermont and Vermont's ability to attract new business;

(ii)

the fact that Merchants' earnings depend to a great extent upon the level of net interest income (the difference between interest income earned on loans and investments and the interest expense paid on deposits and other borrowings) generated by Merchants and thus Merchants' results of operations may be adversely affected by increases or decreases in interest rates or by the shape of the yield curve;

(iii)

the fact that the banking business is highly competitive and the profitability of Merchants depends upon Merchants' ability to attract loans and deposits in Vermont, where Merchants competes with a variety of traditional banking and nontraditional institutions such as credit unions and finance companies;

(iv)

the fact that at December 31, 2007, approximately 50.1% of Merchants' loan portfolio was comprised of commercial, commercial real estate and construction loans with some relationships exceeding ten million dollars, exposing Merchants to the risks inherent in financings based upon analyses of credit risk, the value of underlying collateral, including real estate, and other more intangible factors, which are considered in making commercial loans;

(v)

the fact that if real estate values in Merchants' market decline or become stagnant, business could be adversely affected. At December 31, 2007, approximately 86.2% of Merchants' loan portfolio was comprised of residential and commercial real estate and construction loans, exposing Merchants to the risks inherent in financings based upon analyses of credit risk and the value of underlying collateral. Some areas of the United States have recently experienced decline or stagnation in real estate prices, and significant decline in real estate construction and housing starts. These trends could ultimately impact the value and liquidity of the real estate or other collateral securing Merchants' loans. Merchants' profitability may be negatively impacted by errors in risk analyses, by loan defaults, and the ability of certain borrowers to repay such loans may be adversely affected by any downturn in general economic conditions;

(vi)

the fact that acts or threats of terrorism and actions taken by the United States or other governments as a result of such acts or threats, including possible military action, could further adversely affect business and economic conditions in the United States generally and in Merchants' markets, which could adversely affect Merchants' financial performance and that of Merchants' borrowers and on the financial markets and the price of Merchants' common stock;

(vii)

the fact that changes in the extensive laws, regulations and policies governing bank holding companies and their subsidiaries could alter Merchants' business environment or affect Merchants' operations;

(viii)

the fact that the potential need to adapt to industry changes in information technology systems, on which Merchants is highly dependent to secure bank and customer financial information, could present operational issues, require significant capital spending or impact Merchants' reputation;

(ix)

the fact that Merchants' customers conduct their business within global financial systems, which may subject Merchants' customers' data to potential risks or weaknesses within those systems; and

(x)

the fact that Merchants actively evaluates acquisition and other expansion opportunities and strategies, the implementation of which could affect Merchants' financial performance.

<PAGE>  3

These factors, as well as general economic and market conditions in the United States of America, may materially and adversely affect the market price of shares of Merchants' common stock. Because of these and other factors, past financial performance should not be considered an indicator of future performance. The forward looking statements contained herein represent Merchants' judgment as of the date of this Form 10-K; Merchants cautions readers not to place undue reliance on such statements.

 

PART I

 

ITEM 1 - BUSINESS

 

GENERAL

 

Merchants Bancshares, Inc. is a bank holding company originally organized under Vermont law in 1983 (and subsequently reincorporated in Delaware) for the purposes of owning all of the outstanding capital stock of The Merchants Bank ("Merchants Bank") and providing greater flexibility in helping Merchants Bank achieve its business objectives. Merchants Bank, which is Merchants Bancshares' primary subsidiary, is a Vermont commercial bank with 36 full-service banking offices.

 

Merchants Bank was organized in 1849 and assumed a national bank charter in 1865, becoming The Merchants National Bank of Burlington, Vermont. On September 6, 1974, The Merchants National Bank of Burlington converted its national charter to a Vermont state commercial bank charter, adopting its current name, Merchants Bank. As used herein the term "Merchants" shall mean Merchants Bancshares, Inc. and its subsidiaries unless otherwise noted or the context otherwise requires. As of December 31, 2007, Merchants operated one of the largest commercial banking operations in Vermont, with deposits totaling $867 million, gross loans of $732 million, and total assets of $1.17 billion.

 

Merchants Trust Company, a wholly owned subsidiary of Merchants Bank, is a Vermont corporation chartered in 1870 for the purpose of offering fiduciary services including trust management and administration, investment management and estate settlement services. As of December 31, 2007, Merchants Trust Company had fiduciary responsibility for assets having a market value in excess of $410 million, of which more than $349 million constituted managed assets. Total revenue of Merchants Trust Company for 2007 was $1.96 million and total expenses were $1.56 million.

 

Merchants Properties, Inc., a wholly owned subsidiary of Merchants Bancshares, Inc. was organized for the purpose of developing and owning affordable rental housing units throughout the state of Vermont. Merchants Properties, Inc. owned one development located in Enosburg, Vermont, consisting of a 24-unit low-income family rental housing project. This housing project was sold in December 2007. Total assets of Merchants Properties, Inc. at the time of the sale were approximately $935 thousand.

 

MBVT Statutory Trust I was formed on December 15, 2004 as part of Merchants' private placement of an aggregate of $20 million of trust preferred securities through a pooled trust preferred program. The Trust was formed for the sole purpose of issuing non-voting capital securities. The proceeds from the sale of the capital securities were loaned to Merchants under deeply subordinated debentures issued to the Trust. The debentures are the only asset of the Trust and payments under the debentures are the sole revenue of the Trust.

 

RETAIL SERVICES

 

Merchants' products are designed to provide high value within a defined range of offerings. Individual categories are anchored by lead products that are attractively packaged and easy for Merchants' staff to deliver. Merchants has consciously focused on business lines that are supportable at the most competitive standard. The business lines it has chosen are robust, with employees proficient in selling and servicing all programs. Merchants' believes that its customers appreciate the value that is offered via well defined product features and services that function in a straightforward, effective manner. That formula, in combination with highly motivated and well-trained front line professionals, provides the company with a competitive strength in its markets.

<PAGE>  4

Merchants' retail deposit products include interest bearing and non-interest bearing checking accounts, money market accounts, club accounts, health savings accounts, and short-term and long-term certificates of deposit including a popular flexible CD instrument. Merchants also offers customary check collection services, wire transfers, safe deposit box rentals, and automated teller machine ("ATM") and debit cards. Credit programs include secured and unsecured installment lending, home equity lines of credit, home mortgages, and credit cards (in partnership with a third party).

 

Free Checking For Life® is available to all applicants of good standing in Merchants' market area, and is free of monthly service charges for the life of the account. The only condition to holding the account is that the customer accept check safekeeping, now a relatively standard element of most checking products around the industry. The account pays interest at tiered levels beginning with the first dollar, and no minimum balance is required.

 

Free Checking For Life customers may choose either a Debit Card or an ATM card. Customers who choose the Debit Card can pay for purchases at locations that accept VISA®. Customers can use a money market account and/or a home equity line of credit as overdraft coverage for a checking account. The customer may choose either or both accounts to cover overdrafts via an automatic transfer of funds ("ATF").

 

Merchants introduced its new Cash Rewards Checking account in early 2008. The account has a cash back reward feature that pays customers 1% of all point of sale purchases. The account pays interest and is free of service charges as long as customers maintain minimum average balances.

 

Merchants' primary retail deposit savings product is its money market account. The money market account pays interest at tiered levels beginning with the first dollar in the account, and fees are charged only under certain limited circumstances. Merchants' rates on this product remained competitive during the last year, but were not at the top of the market. New account activity rose slightly during 2007, with average individual account balances dropping. The low minimum balance to open this account combined with the minimum average balance threshold to avoid monthly service charges makes this an attractive savings vehicle.

 

Merchants' flexible certificate of deposit allows multiple deposits and penalty free withdrawals within regulatory guidelines. It is an attractive alternative for customers who wish to retain some of the liquidity features of a money market or savings account while receiving a higher yield than what is offered by those accounts.

 

Merchants offers ATF to cover overdrafts, electronic funds transfer to automate transfers between accounts, and an automated telephone banking system. Merchants offers a free online banking service, as well as a free bill payment service delivered via the Internet, which has proven to be a widely used feature.

 

Each of Merchants' 36 full-service banking offices is led by a branch president who has responsibility for the full range of retail and small business credit services. Merchants' semi-autonomous branch system is core to its strategy of providing one-stop shopping to its customers. Currently most customer inquiries can be handled at any branch location. The branch serves as both a sales and a delivery channel. Branch personnel can explain various deposit options and open new accounts online via internal systems. Additionally, qualified branch staff have the ability to take loan applications, approve loans within defined approval limits, and to close consumer, mortgage and small business loans. Merchants also operates 44 ATMs throughout Vermont, and maintains a customer call center with expanded hours of operation. Customer calls are answered by well-trained employees operating from Merchants' Service Center in South Burlington. There is no automated attendant for distributing customer inquiries via menu options.

 

Work was done to build relationships with all of Merchants' households via a communication process known as XSell. More of the mortgage and home equity options were introduced to customers, with continued growth of the residential portfolio as a result. Financing is available for one-to-four-family residential mortgages, residential construction and seasonal dwelling mortgages. Merchants offers both fixed rate and adjustable rate mortgages for residential properties, and provides a unique two-way rate lock protection feature. Merchants currently holds all originated mortgages in its loan portfolio.

 

Merchants offers a wide variety of consumer loans. Home improvement and home equity lines of credit and various personal loans are available. Financing is also provided for new or used automobiles, boats, airplanes, recreational vehicles and new mobile homes.

<PAGE>  5

COMMERCIAL SERVICES

 

Merchants' corporate sales staff services the majority of the commercial customers, which are primarily larger operating companies, real estate investors and developers. Nine corporate banking officers and ten corporate banking administrators provide commercial credit, deposit and cash management services throughout Vermont to customers requiring business credit above the prescribed authorities of the branch presidents. Branch presidents are trained for small business loan origination and to serve deposit and cash management needs of small businesses.

 

Financing is available for business inventory, accounts receivable, fixed assets, real estate, working capital, and community development. Merchants offers installment loans, credits lines, time loans, construction loans, irrevocable letters of credit, U.S. Small Business Administration guaranteed loans and USDA guaranteed loans. Merchants has increased the emphasis placed on small business loans originated in its branches.

 

Merchants offers a package of business banking services including a low cost business checking account, a money market account, and a streamlined overdraft protection line of credit application. Merchants' philosophy of simplifying product offerings and minimizing fees has been applied to this program. Consistent with Merchants' goal of promoting electronic transactions, this package also provides Internet banking, bill payment, a debit card and electronic payment options. Branch presidents are trained to offer this service leading with the introduction of small business deposit options and the value of utilizing the efficient transaction accounts.

 

Merchants offers a variety of commercial checking accounts. Commercial checking uses an earnings credit rate to help offset service charges. In early 2007 business checking was enhanced by eliminating the monthly fee and offering up to 500 free items per month, making it a low cost checking account that is appropriate for all but high volume commercial deposit customers. Merchants offers a business money market account as the savings vehicle for businesses. Merchants' business money market account pays interest at tiered levels beginning with the first dollar in the account. Commercial customers can use a money market account as overdraft coverage for a checking account.

 

Merchants' cash management services include investment sweep, line of credit sweep, multiple sweep, and funds concentration. Merchants offers an overnight cash management sweep program. Balances are swept to an overnight repurchase agreement structure which allows Merchants to retain those cash balances. The repurchase agreements were a favorable funding source for Merchants in 2007.

 

Merchants also offers remote deposit capture. This service enables commercial customers to deposit checks electronically into Merchants' checking accounts from their business location.

 

Merchants offers commercial online banking, a commercial banking and bill payment service delivered via the Internet. This service allows businesses to view their account histories, print statements, view check images, order stop payments, transfer between accounts, transmit ACH batches, and order wire transfers. Other miscellaneous commercial banking services include lock box services, night depository, coin and currency handling, and balance reporting services.

 

COMPETITION

 

Merchants' competitive landscape continued to change during 2007. At the beginning of 2007 there were 17 financial institutions headquartered in the State of Vermont. Between the second quarter of 2007 and the beginning of 2008 five of those financial institutions were sold. Four of the financial institutions were sold to banks headquartered outside of the state, two of the four are now part of a New Hampshire company, one is part of a Massachusetts company and one is part of a Connecticut company. None of the sales immediately resulted in any office closures or reduction in competition. The most noticeable impact was concentrated in management and product changes.

 

Like most financial institutions in America, Merchants competes with an ever-increasing array of financial service providers. As the national economy moves further toward a concentration of financial service companies, competitive pressures mount. Merchants competes in Vermont for deposit and loan business with numerous other commercial and savings banks, savings and loan associations, credit unions, and other non-bank financial providers. As of De-

<PAGE>  6

cember 31, 2007, there were more than 20 state and national banking institutions operating in Vermont. As a bank holding company and state-chartered commercial bank, Merchants is subject to extensive regulation and supervision, including, in many cases, regulation that limits the type and scope of its activities. The non-bank financial service providers that compete with Merchants may be subject to less restrictive regulation and supervision. Competition from nationally chartered banks, as well as local institutions, continues to be aggressive.

 

Merchants expects to see continued competitive pressure on its franchise. Merchants is the only state-wide independent bank headquartered in the state of Vermont. Assertive direct marketing of core financial products continues to result in increased market share, even in mature market areas. Several smaller community banks and credit unions have continued their commitment to increase their footprints in Merchants' markets. In a state that already has one of the nation's highest branch-to-population ratios it is necessary to have a very competitive product offering and exceptional service levels in order to compete effectively.

 

The fact that Merchants is a locally managed, independent bank contributed significantly to the growth in commercial loans during 2007. Several customers cited the local management and decision-making as important considerations when choosing a bank. The fact that several national or regional competitors operate as branches of a much larger company influenced some portion of the market that wanted to bank locally. This differentiation may become heightened with the sale of several independent companies in the past twelve months.

 

From a retail product standpoint, Merchants has seen a significant change in its competitive landscape in the past few years. When Merchants' free checking product was introduced there was only one other competitor with a similar product offering. Since that time all of Merchants' largest competitors have introduced free checking products. Merchants continues to see free checking as the major driver in its new household penetration, but believes the proliferation of competitive offerings available has significantly impacted the rate of growth. Merchants will need to continue adapting existing products and developing new offerings to remain competitive.

 

No material part of Merchants' business is dependent upon one, or a few, customers, or upon a particular industry segment, the loss of which would have a material adverse impact on the operations of Merchants.

 

NUMBER OF EMPLOYEES

 

As of December 31, 2007, Merchants Bancshares, Inc. had three officers: Michael R. Tuttle, President and Chief Executive Officer; Janet P. Spitler, Chief Financial Officer and Treasurer; and Lisa Razo, Secretary. As of December 31, 2007, Merchants Bank employed 259 full-time and 45 part-time employees and Merchants Trust Company employed 11 full-time employees, representing a combined full time equivalent complement of 296 employees. Merchants Bank and Merchants Trust Company maintain comprehensive employee benefits programs for employees, which provide major medical insurance, hospitalization, dental insurance, long-term and short-term disability insurance, life insurance and a 401(k) Plan. Merchants Bank believes that relations with its employees are good.

 

REGULATION AND SUPERVISION

 

General

As a bank holding company registered under the Bank Holding Company Act of 1956, as amended (the "BHCA"), Merchants is subject to extensive regulation and supervision by the Board of Governors of the Federal Reserve System. As a state-chartered commercial bank, Merchants Bank is subject to substantial regulation and supervision by the Federal Deposit Insurance Corporation (the "FDIC") and by applicable Vermont regulatory agencies. To the extent that the following information describes statutory or regulatory provisions, it is qualified in its entirety by reference to those particular statutory provisions. Any change in applicable law or regulation may have a material effect on the business and prospects of Merchants.

 

Financial Services Modernization

The Gramm-Leach-Bliley Act ("Gramm-Leach"), which significantly altered banking laws in the United States, was signed into law in 1999. Gramm-Leach enabled combinations among banks, securities firms and insurance companies beginning in 2000. As a result of Gramm-Leach, many of the depression-era laws which restricted these affilia-

<PAGE>  7

tions and other activities which may be engaged in by banks and bank holding companies were repealed. Under Gramm-Leach bank holding companies are permitted to offer their customers virtually any type of service that is financial in nature or incidental thereto, including banking, securities underwriting, insurance (both underwriting and agency), and merchant banking.

 

In order to engage in these new financial activities a bank holding company must qualify and register with the Federal Reserve Board as a "financial holding company" by demonstrating that each of its bank subsidiaries is "well capitalized", "well managed," and has at least a "satisfactory" rating under the Community Reinvestment Act of 1977 ("CRA").

 

These new financial activities authorized by Gramm-Leach may also be engaged in by a "financial subsidiary" of a national or state bank, except for insurance or annuity underwriting, insurance company portfolio investments, real estate investment and development, and merchant banking, which must be conducted in a financial holding company. In order for the new financial activities to be engaged in by a financial subsidiary of a national or state bank, Gramm-Leach requires the parent bank (and its sister-bank affiliates) to be "well capitalized" and "well managed"; the aggregate consolidated assets of all of that bank's financial subsidiaries may not exceed the lesser of 45% of its consolidated total assets or $50 billion; the bank must have at least a "satisfactory" CRA rating; and, if that bank is one of the 100 largest national banks, it must meet certain financial rating or other comparable requirements. Gramm-Leach establishes a system of functional regulation, under which the federal banking agencies will regulate the banking activities of financial holding companies and banks' financial subsidiaries, the U.S. Securities and Exchange Commission (the "SEC") will regulate their securities activities and state insurance regulators will regulate their insurance activities. Gramm-Leach also provides new protections against the transfer and use by financial institutions of consumers' non-public, personal information.

 

Bank Holding Company Regulation

Although Merchants believes that it meets the qualifications to become a financial holding company under Gramm-Leach, it has elected to retain its pre-Gramm-Leach bank holding company regulatory status for the present time. This means that Merchants can engage in those activities which are closely related to banking. Merchants is required by the BHCA to file an annual report and additional reports required with the Federal Reserve Board. The Federal Reserve Board also makes periodic inspections of Merchants and its subsidiaries.

 

The BHCA requires every bank holding company to obtain the prior approval of the Federal Reserve Board before it may acquire substantially all of the assets of any bank, or ownership or control of any voting shares of a bank, if, after such acquisition, it would own or control, directly or indirectly, more than five percent of the voting shares of such bank. Additionally, as a bank holding company Merchants is prohibited from acquiring ownership or control of five percent or more of any class of voting securities of any company that is not a bank, or from engaging in activities other than banking or controlling banks except where the Federal Reserve Board has determined that such activities are so closely related to banking as to be a "proper incident thereto."

 

Dividends

Merchants Bancshares, Inc. is a legal entity separate and distinct from Merchants Bank and its other non-bank subsidiary. The revenue of Merchants (on a parent company only basis) is derived primarily from interest and dividends paid to it by its subsidiaries. The right of Merchants, and consequently the right of shareholders of Merchants, to participate in any distribution of the assets or earnings of any subsidiary through the payment of such dividends or otherwise is necessarily subject to the prior claims of creditors of the subsidiary (including depositors, in the case of banking subsidiaries), except to the extent that certain claims of Merchants in a creditor capacity may be recognized.

 

The payment of dividends by Merchants is determined by its Board of Directors based on Merchants' consolidated liquidity, asset quality profile, capital adequacy, and recent earnings history, as well as economic conditions and other factors, including applicable government regulations and policies and the amount of dividends payable to Merchants by its subsidiaries.

 

It is the policy of the Federal Reserve Board that banks and bank holding companies, respectively, should pay dividends only out of current earnings and only if, after paying such dividends, the bank or bank holding company would

<PAGE>  8

remain adequately capitalized. Federal banking regulators also have authority to prohibit banks and bank holding companies from paying dividends if they deem such payment to be an unsafe or unsound practice. In addition, it is the position of the Federal Reserve Board that a bank holding company is expected to act as a source of financial strength to its subsidiary banks.

 

Vermont law requires the approval of state bank regulatory authorities if the dividends declared by state banks exceed prescribed limits. The payment of any dividends by Merchants' subsidiaries will be determined based on a number of factors, including the subsidiary's liquidity, asset quality profile, capital adequacy and recent earnings history.

 

Capital Adequacy and Safety and Soundness

Capital Guidelines. Under the uniform capital guidelines adopted by the Federal banking agencies, in order to be "well capitalized" a financial institution must have a minimum ratio of total capital to risk-adjusted assets of ten percent (including certain off-balance sheet items, such as standby letters of credit), a minimum ratio of Tier 1 capital to total risk-based assets of six percent (comprised of common equity, retained earnings, minority interests in the equity accounts of consolidated subsidiaries and a limited amount of noncumulative perpetual preferred stock, less deductible intangibles), and a minimum leverage ratio of five percent (Tier 1 capital to average quarterly assets, net of goodwill). As of December 31, 2007, Merchants and Merchants Bank were "well capitalized" under the uniform capital guidelines.

 

Under Federal banking laws, failure to meet the minimum regulatory capital requirements could subject a banking institution to a variety of enforcement remedies available to federal regulatory authorities, including the termination of deposit insurance by the FDIC and seizure of the institution.

 

Prompt Corrective Action. The Federal Deposit Insurance Corporation Improvement Act of 1991 (as amended) (the "FDICIA") provides the Federal banking agencies with broad powers to take prompt corrective action to resolve problems of insured depository institutions, depending upon a particular institution's level of capital. The FDICIA establishes five tiers of capital measurement for regulatory purposes ranging from "well capitalized" to "critically undercapitalized." A depository institution may be deemed to be in a capitalization category that is lower than is indicated by its actual capital position under certain circumstances. As of December 31, 2007, Merchants Bank was classified as "well capitalized" under the applicable prompt corrective action regulations.

 

Under the FDICIA a depository institution that is "well capitalized" may accept brokered deposits. A depository institution that is adequately capitalized may accept brokered deposits only if it obtains the approval of the FDIC, and may not offer interest rates on deposits "significantly higher" than the prevailing rate in its market. An "undercapitalized" depository institution may not accept brokered deposits. Merchants had no brokered deposits at December 31, 2007.

 

Safety and Soundness Standards. The FDICIA, as amended, directs each Federal banking agency to prescribe safety and soundness standards for depository institutions relating to internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, asset-quality, earnings and stock valuation. The Community Development and Regulatory Improvement Act of 1994 amended the FDICIA by allowing Federal banking activities to publish guidelines rather than regulations concerning safety and soundness.

 

The FDICIA also contains a variety of other provisions that may affect Merchants' operations, including reporting requirements, regulatory guidelines for real estate lending, "truth in savings" provisions, and the requirement that a depository institution give 90 days prior notice to customers and regulatory authorities before closing any branch.

 

Deposit Insurance. The Federal Deposit Insurance Reform Act of 2005, which was signed into law on February 8, 2006, gave the FDIC increased flexibility in assessing premiums on banks and savings associations to pay for deposit insurance and in managing its deposit insurance reserves. During 2006, the FDIC adopted rules to implement its new authority to set deposit insurance premiums. Under these regulations, all insured depository institutions pay a base rate, which may be adjusted annually up to 3 basis points by the FDIC, and an additional assessment based on the risk of loss to the Deposit Insurance Fund posed by that institution. For institutions that have a long-term public debt rating, the risk assessment is based on its debt rating and the components of its supervisory rating. For institutions such as Merchants that do not have a long-term public debt

<PAGE>  9

rating, the risk assessment is based on certain measurements of its financial condition and its supervisory ratings. Assessment rates set by the FDIC effective January 1, 2007 will range from 5 to 43 basis points. The reform legislation also provided a credit to insured institutions based on the amount of their insured deposits at year-end 1996 which will offset the premiums assessed. Merchants Bank's credit of $693 thousand offset its 2007 deposit insurance assessment and will offset a portion of its 2008 assessment, based upon an anticipated rate of 5 basis points.

 

Community Reinvestment Act

Pursuant to the CRA and similar provisions of Vermont law, regulatory authorities review the performance of Merchants in meeting the credit needs of the communities it serves. The applicable regulatory authorities consider compliance with this law in connection with the applications for, among other things, approval for de novo branches, branch relocations and acquisitions of banks and bank holding companies. Merchants received a "satisfactory" rating at its most recent CRA examination.

 

Interstate Banking Act

The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, as amended (the "Interstate Banking Act"), generally permits bank holding companies to acquire banks in any state, and preempts all state laws restricting the ownership by a bank holding company of banks in more than one state. The Interstate Banking Act also permits a bank to merge with an out-of-state bank and convert any offices into branches of the resulting bank if both states have not opted out of interstate branching; permits a bank to acquire branches from an out-of-state bank if the law of the state where the branches are located permits the interstate branch acquisition; and permits banks to establish and operate de novo interstate branches whenever the host state opts-in to de novo branching. Bank holding companies and banks seeking to engage in transactions authorized by the Interstate Banking Act must be adequately capitalized and managed.

 

USA Patriot Act

Under Title III of the USA Patriot Act, also known as the "International Money Laundering Abatement and Anti-Terrorism Financing Act of 2001," all financial institutions are required in general to identify their customers, adopt formal and comprehensive anti-money laundering programs, scrutinize or prohibit altogether certain transactions of special concern, and be prepared to respond to inquiries from U.S. law enforcement agencies concerning their customers and their transactions. Additional information-sharing among financial institutions, regulators, and law enforcement authorities is encouraged by the presence of an exemption from the privacy provisions of Gramm-Leach for financial institutions that comply with this provision and the authorization of the Secretary of the Treasury to adopt rules to further encourage cooperation and information-sharing. The effectiveness of a financial institution in combating money laundering activities is a factor to be considered in any application submitted by the financial institution under the Bank Merger Act and Bank Holding Company Act.

 

Sarbanes-Oxley Act of 2002

The Sarbanes-Oxley Act of 2002, signed into law July 30, 2002, addresses, among other issues, corporate governance, auditor independence and accounting standards, executive compensation, insider loans, whistleblower protection and enhanced and timely disclosure of corporate information. The SEC has adopted a substantial number of implementing rules, and the National Association of Securities Dealers, Inc. has adopted corporate governance rules applicable to Merchants that have been approved by the SEC. The changes are intended to allow shareholders to monitor more effectively the performance of companies and management.

 

As directed by Section 302(a) of the Sarbanes-Oxley Act of 2002, Merchants' chief executive officer and chief financial officer are each required to certify that Merchants' quarterly and annual reports do not contain any untrue statement of a material fact, or omit to state a material fact to make the statements made not misleading. This requirement has several parts, including certification that these officers are responsible for establishing and maintaining Merchants' disclosure controls and procedures and internal control over financial reporting and evaluating the effectiveness of such disclosure controls and procedures. The officers certify that they have made certain disclosures to Merchants' auditors and the Audit Committee of the board of directors about Merchants' internal control over financial reporting and evaluating the effectiveness of such disclosure controls and procedures. In addition, the officers

<PAGE>  10

also certify that they have disclosed in this report any change in the registrant's internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting.

 

Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350, Merchants' chief executive officer and chief financial officer are each required to certify that Merchants' quarterly and annual reports fully comply with the requirements of Sections 13(a) or 15(d) of the Securities Exchange Act and that the information contained in the report fairly presents, in all material respects, Merchants' financial condition and results of operations.

 

Other Proposals

Other legislative and regulatory proposals regarding changes in banking, the regulation of banks and other financial institutions, and public companies generally, are regularly considered by the executive branch of the Federal government, Congress and various state governments, including Vermont, and state and federal regulatory authorities. It cannot be predicted what additional legislative and/or regulatory proposals, if any, will be considered in the future, whether any such proposals will be adopted or, if adopted, how any such proposals would affect Merchants.

 

Available Information

Merchants files annual, quarterly, and current reports, proxy statements, and other documents with the SEC under the Exchange Act. The public may read and copy any materials that Merchants has filed with the SEC at the SEC's Public Reference Room at 100 F Street, NE, Room 2521, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. Also, the SEC maintains an Internet website that contains reports, proxy and information statements, and other information regarding issuers, including Merchants, that file electronically with the SEC. The public can obtain any documents that Merchants has filed with the SEC at the SEC website (sec.gov).

 

Merchants also makes available free of charge on or through its Internet website (mbvt.com) its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and, if applicable, amendments to those reports filed or furnished pursuant to Section 13(a) of the Exchange Act, as soon as reasonably practicable after Merchants electronically files such materials with or furnishes them to the SEC. Merchants also makes all filed insider transactions available through its website free of charge. In addition, Merchants' Audit Committee and Nominating and Governance Committee Charters as well as its Code of Ethics Policy for Senior Financial Officers are available free of charge on its website.

 

ITEM 1A - RISK FACTORS

 

Merchants has identified the following risk factors that may affect its performance and results of operations:

(i)

the fact that Merchants' success is dependent upon general economic conditions in Vermont and Vermont's ability to attract new business, as well as global and national economic conditions;

(ii)

the fact that Merchants' earnings depend to a great extent upon the level of Merchants' net interest income (the difference between interest income earned on loans and investments and the interest expense paid on deposits and other borrowings) generated by Merchants and thus Merchants' results of operations may be adversely affected by increases or decreases in interest rates or by the shape of the yield curve;

(iii)

the fact that the banking business is highly competitive and the profitability of Merchants depends upon Merchants' ability to attract loans and deposits in Vermont, where Merchants competes with a variety of traditional banking and nontraditional institutions such as credit unions and finance companies;

(iv)

the fact that at December 31, 2007, approximately 50.1% of Merchants' loan portfolio was comprised of commercial, commercial real estate and construction loans with some relationships exceeding ten million dollars, exposing Merchants to the risks inherent in financings based upon analyses of credit risk, the value of underlying collateral, including real estate, and other more intangible factors, which are considered in making commercial loans;

<PAGE>  11

(v)

the fact that if real estate values in Merchants' market decline or become stagnant, business could be adversely affected. At December 31, 2007, approximately 86.2% of Merchants' loan portfolio was comprised of residential and commercial real estate and construction loans, exposing Merchants to the risks inherent in financings based upon analyses of credit risk and the value of underlying collateral. Real estate prices in some parts of the country have recently become stagnant or declined and there has been a significant decline in real estate construction and housing starts. These trends could ultimately impact the value and liquidity of the real estate or other collateral securing Merchants' loans. Merchants' profitability may be negatively impacted by errors in risk analyses, by loan defaults, and the ability of certain borrowers to repay such loans may be adversely affected by any downturn in general economic conditions;

(vi)

the fact that acts or threats of terrorism and actions taken by the United States or other governments as a result of such acts or threats, including possible military action, could further adversely affect business and economic conditions in the United States of America generally and in Merchants' markets, which could adversely affect Merchants' financial performance and that of Merchants' borrowers and on the financial markets and the price of Merchants' common stock;

(vii)

the fact that changes in the extensive laws, regulations and policies governing bank holding companies and their subsidiaries could alter Merchants' business environment or affect Merchants' operations;

(viii)

the fact that the potential need to adapt to industry changes in information technology systems, on which Merchants is highly dependent to secure bank and customer financial information, could present operational issues, require significant capital spending or impact Merchants' reputation;

(ix)

the fact that Merchants' customers conduct their business within global financial systems, which may subject Merchants' customers' data to potential risks or weaknesses within those systems; and

(x)

the fact that Merchants actively evaluates acquisition and other expansion opportunities and strategies, the implementation of which could affect Merchants' financial performance.

 

ITEM 1B - UNRESOLVED STAFF COMMENTS

 

Merchants has no unresolved comments from the SEC staff.

 

ITEM 2 - PROPERTIES

 

As of December 31, 2007, Merchants operated 36 full-service banking offices, and 44 ATMs throughout the state of Vermont. Merchants' headquarters are located in Merchants' service center at 275 Kennedy Drive, South Burlington, Vermont, which also houses Merchants' operations and administrative offices and Merchants Trust Company.

 

Merchants leases certain premises from third parties under current market terms and conditions. The offices of all subsidiaries are in good physical condition with modern equipment and facilities considered adequate to meet the banking needs of customers in the communities served. Additional information relating to Merchants' properties is set forth in Note 4 to the consolidated financial statements included in Item 8 of this 2007 Annual Report on Form 10-K.

 

ITEM 3 - LEGAL PROCEEDINGS

 

Merchants and certain of its subsidiaries have been named as defendants in various legal proceedings arising from their normal business activities. Although the amount of any ultimate liability with respect to such proceedings cannot be determined, in the opinion of management, based upon the opinion of counsel on the outcome of such proceedings, any such liability will not have a material effect on the consolidated financial position of Merchants and its subsidiaries.

 

ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

During the fourth quarter of calendar year 2007 no matters were submitted to a vote of Merchants' security holders through a solicitation of proxies or otherwise.

<PAGE>  12

PART II

 

ITEM 5 - MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS

                AND ISSUER PURCHASES OF EQUITY SECURITIES

 

The common stock of Merchants is traded on the NASDAQ National Stock Market under the trading symbol MBVT. Quarterly stock prices and dividends per share paid for each quarterly period during the last two years were as follows:

 
       

Dividends

 
 

Quarter Ended

High

Low

Paid

 
 


 
 

December 31, 2007

$24.00

$20.82

$0.28

 
 

September 30, 2007

  24.55

  22.59

  0.28

 
 

June 30, 2007

  24.40

  22.10

  0.28

 
 

March 31, 2007

  23.95

  22.16

  0.28

 
 

December 31, 2006

  24.00

  19.95

  0.28

 
 

September 30, 2006

  24.92

  23.35

  0.28

 
 

June 30, 2006

  24.55

  23.45

  0.28

 
 

March 31, 2006

  25.11

  23.35

  0.28

 
 

High and low stock prices are based upon quotations as provided by the National Association of Securities Dealers, Inc. Prices of transactions between private parties may vary from the ranges quoted above.

 

Performance Graph

The line-graph presentation below compares cumulative five-year shareholder returns with the NASDAQ Banks and the Russell 2000 Index. The comparison assumes the investment, on 12/31/2002, of $100 in Merchants' common stock and each of the foregoing indices and reinvestment of all dividends.

 

 

Company/Index/Market

2002

2003

2004

2005

2006

2007


Merchants

100.00

140.72

161.81

139.61

139.48

150.12

NASDAQ Banks

100.00

129.93

144.21

137.97

153.15

119.35

Russell 2000 Index

100.00

147.25

174.24

182.18

215.64

212.26


<PAGE>  13

The graph and related information furnished under Part II Item 5 of this Form 10-K shall not be deemed to be "soliciting material" or to be "filed" with the SEC, or subject to Regulation 14A or 14C (17 CFR 240.14a-1-240.14a-104 or 240.14c-101), other than as provided in Item 201 of Regulation S-K, or to the liabilities of section 18 of the Exchange Act, as amended, except to the extent that Merchants specifically requests that such information be treated as soliciting material. Such information shall not be incorporated by reference into any future filing under the Securities Act or Exchange Act, each as amended, except to the extent that Merchants specifically incorporates it by reference into such filing.

 

Securities Authorized for Issuance under Equity Compensation Plans

Merchants maintained two equity compensation plans: the Deferred Compensation Plan for Non-Employee Directors (the "deferred compensation plan") and the Long Term Incentive/Stock Option Plan (the "stock option plan"). Each of these plans was approved by Merchants' stockholders, both plans expired in May 2007 and new plans will be presented to Merchants' shareholders for their approval in May 2008. The following table includes information as of December 31, 2007 about these plans which provide for the issuance of common stock in connection with the exercise of stock options and other share-based awards.

 

Period

Number of Securities
to be Issued Upon
Exercise of
Outstanding Options,
Warrants and Rights

Weighted Average
Price of
Outstanding
Options,
Warrants and
Rights

Number of Securities
Remaining Available for
Future Issuance Under
Equity Compensation
Plans (Excluding
Securities Reflected in
First Column)


Equity Compensation Plans
  Approved by Security Holders


129,475 (a)


$19.25 (b)


--

       

Equity Compensation Plans Not
  Approved by Security Holders


--


--


--

 


Total

129,475     

$19.25     

 
 


   

(a)

This number does not include an aggregate of 325,789 shares then outstanding under the deferred compensation plan.

(b)

This price reflects the weighted-average exercise price of outstanding stock options.

   

Purchases of Issuer Equity Securities by the Issuer

The following table provides information with respect to purchases Merchants made of its common stock during the three months ended December 31, 2007:

 

Period

Total Number
of Shares
Purchased

Average
Price Paid
per Share

Total Number of
Shares Purchased as
Part of Publicly
Announced Plans
or Programs

Maximum Number
of Shares that May Yet
Be Purchased Under
the Plans or Programs


October 1 - 31, 2007

--

$     --

--

162,859

November 1 - 30, 2007

  9,520

$22.68

  9,096

153,763

December 1 - 31, 2007

14,861

$23.65

12,881

140,882

 


Total

24,381

$23.27

21,977

 
 


 

In January 2007 Merchants' Board of Directors (the "Board") approved a stock repurchase program, pursuant to which Merchants may repurchase 200,000 shares of its stock from time to time through January 2008. The Board extended the program through January 2009 at its January 2008 meeting. Through December 31, 2007, Merchants purchased 59,118 shares of its common stock on the open market under the program at an average per share price of $22.89. Through December 31, 2007, Merchants purchased 58,833 shares of its own stock outside of the program with certain shareholders at an average per share price of $23.10. Included in these purchases were two purchases made from the Dudley Hale Davis Estate, of which Mr. Jeffrey L. Davis, a director of Merchants, is executor. On June 28, 2007, Merchants purchased 10,000 shares from the estate and on August 3, 2007, Merchants purchased 43,420 shares from the estate.

<PAGE>  14

As of January 31, 2007, Merchants had 907 registered shareholders. Merchants declared and distributed dividends totaling $1.12 per share during 2007. In January 2008 Merchants declared a dividend of $0.28 per share, which was paid on February 14, 2008, to shareholders of record as of January 31, 2008. Future dividends will depend upon the financial condition and earnings of Merchants and its subsidiaries, its need for funds and other factors, including applicable government regulations.

 

American Stock Transfer & Trust Company provides transfer agent services for Merchants. Inquiries may be directed to: American Stock Transfer & Trust Company, 59 Maiden Lane, New York, New York, 10038, telephone: 1-800-937-5449, Internet address: http://www.amstock.com, or email: info@amstock.com.

 

ITEM 6 - SELECTED FINANCIAL DATA

 

The supplementary financial data presented in the following tables contain information highlighting certain significant trends in Merchants' financial condition and results of operations over an extended period of time.

 

The following information should be analyzed in conjunction with Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations and with the audited consolidated financial statements included in Item 8 of this 2007 Annual Report on Form 10-K.

<PAGE>  15

Merchants Bancshares, Inc.

Five Year Summary of Financial Data

 
 

At or For the Years Ended December 31,

(In thousands except per share data)

2007

 

2006

 

2005

 

2004

 

2003


Results for the Year

                           

Interest and Dividend Income

$

64,599

 

$

61,997

 

$

53,809

 

$

47,432

 

$

45,561

Interest Expense

 

26,386

   

23,289

   

13,874

   

7,876

   

7,933


Net Interest Income

 

38,213

   

38,708

   

39,935

   

39,556

   

37,628

Provision for Loan Losses

 

1,150

   

--

   

--

   

--

   

--


Net Interest Income after Provision for Loan Losses

 

37,063

   

38,708

   

39,935

   

39,556

   

37,628


Noninterest Income

 

9,344

   

8,188

   

7,800

   

7,623

   

8,229

Noninterest Expense

 

32,288

   

32,724

   

32,082

   

31,175

   

29,893


Income before Income Taxes

 

14,119

   

14,172

   

15,653

   

16,004

   

15,964

Provision for Income Taxes

 

3,261

   

3,301

   

3,751

   

4,071

   

4,372


Net Income

$

10,858

 

$

10,871

 

$

11,902

 

$

11,933

 

$

11,592


                             

Share Data

                           


Basic Earnings per Common Share

$

1.77

 

$

1.73

 

$

1.88

 

$

1.91

 

$

1.87

Diluted Earnings per Common Share

$

1.76

 

$

1.73

 

$

1.87

 

$

1.90

 

$

1.86

Cash Dividends Declared per Common Share

$

1.12

 

$

1.12

 

$

1.08

 

$

5.58

 

$

1.04

Weighted Average Common Shares Outstanding (1)

 

6,148,494

   

6,275,709

   

6,318,524

   

6,225,417

   

6,183,919

Period End Common Shares Outstanding (2)

 

6,096,737

   

6,196,328

   

6,290,889

   

6,243,710

   

6,196,053

Year-end Book Value

$

13.05

 

$

11.87

 

$

11.11

 

$

10.91

 

$

14.55

Year-end Book Value (2)

$

12.35

 

$

11.25

 

$

10.55

 

$

10.44

 

$

13.93


                             

Key Performance Ratios

                           


Return on Average Shareholders' Equity

 

15.37%

   

16.24%

   

18.26%

   

13.81%

   

13.75%

Return on Average Assets

 

0.96%

   

0.98%

   

1.13%

   

1.17%

   

1.28%

Tier 1 Leverage Ratio

 

8.14%

   

8.24%

   

8.54%

   

8.09%

   

8.70%

Allowance for Loan Loss to Total Loans at
  Year-end (3)

 


1.09%

   


1.00%

   


1.17%

   


1.29%

   


1.40%

Nonperforming Loans as a Percentage of Total
  Loans

 


1.26%

   


0.39%

   


0.39%

   


0.57%

   


0.39%

Net Interest Margin

 

3.56%

   

3.69%

   

4.03%

   

4.15%

   

4.43%


                             

Average Balances

                           


Total Assets

$

1,131,588

 

$

1,110,701

 

$

1,053,861

 

$

1,016,618

 

$

905,098

Earning Assets

 

1,075,367

   

1,050,123

   

990,495

   

954,428

   

849,366

Loans

 

713,119

   

648,713

   

589,408

   

581,259

   

536,095

Investments

 

325,860

   

394,611

   

400,268

   

372,005

   

304,748

Total Deposits

 

873,674

   

857,022

   

843,952

   

822,828

   

781,927

Shareholders' Equity

 

70,661

   

66,959

   

65,179

   

86,396

   

84,332


                             

At Year-End

                           


Total Assets

$

1,170,743

 

$

1,136,958

 

$

1,075,236

 

$

1,032,405

 

$

969,902

Gross Loans

 

731,508

   

689,283

   

605,926

   

584,332

   

568,997

Allowance for Loan Losses (3)

 

8,002

   

6,911

   

7,083

   

7,512

   

7,954

Investments

 

365,590

   

339,573

   

390,460

   

376,547

   

340,337

Deposits

 

867,437

   

877,352

   

854,576

   

834,164

   

808,083

Shareholders' Equity

 

75,307

   

69,697

   

66,397

   

65,184

   

86,313


 

(1)

Weighted average common shares outstanding includes an average of 319,357; 313,079; 309,268; 261,275 and 255,982 shares held in Rabbi Trusts for deferred compensation plans for directors for 2007, 2006, 2005, 2004, and 2003, respectively.

(2)

Period end common shares outstanding and this book value includes 325,789; 323,038; 314,602; 270,015 and 264,330 shares held in Rabbi Trusts for deferred compensation plans for directors for 2007, 2006, 2005, 2004, and 2003, respectively.

(3)

Effective March 31, 2006 Merchants transferred the portion of the allowance for loan losses related to undisbursed lines of credit to other liabilities.

<PAGE>  16

Merchants Bancshares, Inc.

Summary of Quarterly Financial Information

(Unaudited)

 

(In thousands except per share data)

2007

 

2006


 


 


   

Q4

 

Q3

 

Q2

 

Q1

 

Year

 

Q4

 

Q3

 

Q2

 

Q1

 

Year

   


 


Interest and Dividend Income

 

$16,564

 

$15,984

 

$15,991

 

$16,060

 

$64,599

 

$16,246

 

$15,937

 

$15,279

 

$14,535

 

$61,997

Interest Expense

 

6,936

 

6,482

 

6,423

 

6,545

 

26,386

 

6,485

 

6,075

 

5,823

 

4,906

 

23,289


 


 


Net Interest Income

 

9,628

 

9,502

 

9,568

 

9,515

 

38,213

 

9,761

 

9,862

 

9,456

 

9,629

 

38,708

Provision for Loan Losses

 

300

 

700

 

150

 

--

 

1,150

 

--

 

--

 

--

 

--

 

--

Noninterest Income

 

2,629

 

2,324

 

2,340

 

2,051

 

9,344

 

2,111

 

1,702

 

2,218

 

2,023

 

8,054

Noninterest Expense

 

8,148

 

7,719

 

8,241

 

8,180

 

32,288

 

8,157

 

8,133

 

8,201

 

8,099

 

32,590


 


 


Income before Income Taxes

 

3,809

 

3,407

 

3,517

 

3,386

 

14,119

 

3,715

 

3,431

 

3,473

 

3,553

 

14,172

Provision for Income Taxes

 

893

 

778

 

821

 

769

 

3,261

 

883

 

785

 

802

 

831

 

3,301


 


 


Net Income

 

$  2,916

 

$  2,629

 

$  2,696

 

$  2,617

 

$10,858

 

$  2,832

 

$  2,646

 

$  2,671

 

$  2,722

 

$10,871


 


 


Basic Earnings Per Share

 

$    0.48

 

$    0.43

 

$    0.44

 

$    0.42

 

$    1.77

 

$    0.45

 

$    0.42

 

$    0.42

 

$    0.43

 

$    1.73

Diluted Earnings Per Share

 

0.48

 

0.43

 

0.44

 

0.42

 

1.76

 

0.45

 

0.42

 

0.42

 

0.43

 

1.73


 


 


Cash Dividends Declared
  and Paid Per Share

 

$    0.28

 

$    0.28

 

$    0.28

 

$    0.28

 

$    1.12

 

$    0.28

 

$    0.28

 

$    0.28

 

$    0.28

 

$    1.12

 


 


 


<PAGE>  17

ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

                RESULTS OF OPERATIONS

 

CRITICAL ACCOUNTING POLICIES

 

Management's discussion and analysis of Merchants' financial condition and results of operations is based on the consolidated financial statements which are prepared in accordance with accounting principles generally accepted in the United States. The preparation of such consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. Management evaluates its estimates on an ongoing basis. Management bases its estimates on historical experience and various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis in making judgments about financial statement amounts. Actual results could differ from the amount derived from management's estimates and assumptions under different assumptions or conditions.

 

Merchants' significant accounting policies are described in more detail in Note 1 to the consolidated financial statements included in Item 8 of this Form 10-K. Management believes the following accounting policies are the most critical to the preparation of the consolidated financial statements.

 

Allowance for Credit Losses: The allowance for credit losses ("Allowance") includes the allowance for loan losses and the reserve for undisbursed lines of credit. The Allowance, which is established through the provision for credit losses, is based on management's evaluation of the level of allowance required in relation to the estimated loss exposure in the loan portfolio and undisbursed lines of credit. Management believes the Allowance is a significant estimate and therefore evaluates it for adequacy each quarter. Management considers factors such as previous loss experience, the size and composition of the loan portfolio, current economic and real estate market conditions, the performance of individual loans in relation to contract terms, and estimated fair value of collateral that secures the loans. The use of different estimates or assumptions could produce a different Allowance.

 

Income Taxes: Merchants estimates its income taxes for each period for which a statement of income is presented. This involves estimating Merchants' actual current tax exposure, as well as assessing temporary differences resulting from differing timing of recognition of expenses, income and tax credits, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in Merchants consolidated balance sheets. Merchants must also assess the likelihood that any deferred tax assets will be recovered from future taxable income and, to the extent that recovery is not likely, a valuation allowance must be established. Significant management judgment is required in determining income tax expense, and deferred tax assets and liabilities. As of December 31, 2007 Merchants determined that no valuation allowance for deferred tax assets was necessary.

 

Interest Income Recognition on Loans: Interest on loans is included in income as earned based upon the unpaid principal balance of the loan. Merchants' policy is to discontinue the accrual of interest, and to reverse any uncollected interest recorded on loans, when scheduled payments become contractually past due in excess of 90 days unless the ultimate collectibility of principal and interest is assured.

 

GENERAL

 

The following discussion and analysis of financial condition and results of operations of Merchants and its subsidiaries for the three years ended December 31, 2007 should be read in conjunction with the Consolidated Financial Statements and Notes thereto and selected statistical information appearing elsewhere in this Form 10-K. The information about asset yields, interest rate spreads and net interest margins is discussed on a fully taxable equivalent basis. The financial condition and results of operations Merchants essentially reflect the operations of its principal subsidiary, Merchants Bank. Certain statements contained in this section constitute "Forward-Looking Statements" and are subject to certain risks and uncertainties described in this 10-K under the heading "Forward-Looking Statements".

<PAGE>  18

RESULTS OF OPERATIONS

 

Merchants realized net income of $10.86 million, $10.87 million and $11.90 million for the years ended December 31, 2007, 2006 and 2005, respectively. Basic earnings per share were $1.77, $1.73 and $1.88 and diluted earnings per share were $1.76, $1.73 and $1.87 for the years ended December 31, 2007, 2006 and 2005, respectively. Merchants declared and distributed total dividends of $1.12, $1.12 and $1.08 per share during 2007, 2006 and 2005, respectively. In January 2008, Merchants declared a dividend of $0.28 per share, which was paid on February 14, 2008, to shareholders of record as of January 31, 2008.

 

Net income as a percentage of average equity capital was 15.37%, 16.24% and 18.26% for 2007, 2006 and 2005, respectively. Net income as a percentage of average assets was 0.96%, 0.98% and 1.13% in 2007, 2006 and 2005, respectively.

 

Net Interest Income

 

2007 compared with 2006

Net interest income on a taxable equivalent basis was $38.28 million for 2007, a decrease of $457 thousand from 2006. Merchants' net interest margin has continued to come under pressure during 2007, and decreased 13 basis points to 3.56% from 3.69% during 2007. Rates across the yield curve stayed fairly consistent for the first half of the year, and started moving down as the Federal Reserve Board began easing in August. The two year treasury rate dropped 175 basis points during 2007, while the 10-year dropped 64 basis points, resulting in a spread between the two-year and the ten-year of 99 basis points at year-end compared to a 12 basis point inversion at the beginning of the year. Merchants took advantage of the yield curve steepening to add some leverage to the balance sheet during the fourth quarter. As shown in the following table, total average earning assets increased $25.24 million to $1.08 billion for 2007 compared to 2006, and the rate earned on those assets increased 10 basis points to 6.01% for the same time period. Although the rate earned on Merchants' loan portfolio dropped six basis points during 2007 the continued shift in Merchants' asset mix toward higher yielding loans combined with increases in the average yield earned on the investment portfolio helped to stem further compression on the asset side of the balance sheet. Decreases in average rates earned on loans were a result of both an overall lower interest rate environment for the second half of the year and increases in nonperforming loans. The variable rate portion of the total of Merchants' commercial, commercial construction and commercial mortgage portfolio continued to decrease during 2007, and stood at 36% at year end 2007, compared to 45% at December 31, 2006. This decrease should help to temporarily mitigate recent interest rate decreases. However, the $136 million variable rate portion of Merchants' commercial, commercial construction and commercial real estate portfolios will reprice in conjunction with moves in the federal funds rate. Additionally, customers with fixed rate loans may choose to refinance and lower their rate.

 

The average rate earned on Merchants' investment portfolio increased by 13 basis points during 2007. Merchants was able to replace the amortization of lower yielding bonds at a higher interest rate by extending slightly further out on the yield curve. Merchants' average short term investment position increased $29.59 million to $36.39 million from $6.80 million, the average rate earned on the short term portfolio dropped four basis points to 5.17% from 5.21% as a result of decreases in short term interest rates in the second half of the year. Merchants' year end short-term investment position decreased $21.90 million as these funds were redeployed into the investment portfolio.

 

Merchants' cost of funds increased 29 basis points when comparing 2007 to 2006. Merchants experienced continued migration to its time categories from its transaction categories during the year. Average time deposits for 2007 were $47.86 million higher than for 2006, while average Savings, NOW and Money Market accounts were $33.01 million lower for the same time period. The cost of transaction accounts was essentially unchanged from 2006 to 2007, while the cost of time deposits increased 63 basis points. Merchants raised rates on time deposits during the first three quarters of the year to be competitive in the local marketplace. These rates have started to moderate as short-term interest rates have moved down during the last two quarters. The annual average cost of Merchants' non-deposit funding sources decreased nine basis points to 4.67% from 4.76% during the year. This entire decrease came in the second half of the year, the average cost of these funds was flat for the first two quarters of 2007, and then dropped five basis points during the third quarter and 23 basis points during the fourth quarter.

<PAGE>  19

2006 compared with 2005

Merchants' net interest income on a taxable equivalent basis for 2006 was $38.74 million, a decrease of $1.22 million from net interest income for 2005 of $39.96 million. Merchants experienced decreases in its net interest margin as the spread between the yield on interest earning assets and the cost of interest bearing liabilities continued to shrink. Merchants' margin compression was reflective of the sustained flat to inverted yield curve environment during the 15-18 months leading up to December 2006. During 2006 the federal funds rate increased by 100 basis points, while the ten-year Treasury increased by 34 basis points. The net interest margin for 2006 was 3.69%, compared to 4.03% for 2005. The average rate paid on Merchants' interest bearing liabilities increased 93 basis points to 2.54% for 2006, from 1.61% for 2005. Merchants' non-deposit funding sources experienced the largest rate increase during 2006, increasing 117 basis points to 4.76% for 2006 from 3.59% for 2005. The average rate paid on interest bearing deposits increased 75 basis points to 1.99% for 2006 from 1.24% for 2005. At the same time the average rate earned on Merchants' interest earning assets increased by 47 basis points to 5.91% for 2006, compared to 5.44% for 2005. The average rate earned on the loan portfolio increased 48 basis points to 6.70% from 6.22%, and the average rate earned on the investment portfolio increased 32 basis points to 4.61% from 4.29%. Although asset yields continued to rise in response to higher short-term market rates, funding costs increased further due to deposit pricing pressure and higher cost borrowings.

 

As shown in the following table, Merchants was able to compensate for some of the margin compression through overall balance sheet growth, as well as a shift in the make up of the bank's asset mix. Average interest earning assets increased by $59.63 million during 2006, while most of the growth occurred in the loan portfolio; average loans for 2006 grew by $59.30 million to $648.71 million from $589.41 million. Merchants made the decision, in mid-2006, to discontinue further investment in its securities portfolio; Merchants sold $23 million in securities during the fourth quarter. As a result, the average investment portfolio for 2006 decreased by $5.66 million to $394.61 million from $400.27 million for 2005. The benefit of the shift from investments to loans was mitigated by the continued migration in the loan portfolio toward fixed rate from variable rate loans during the year. At December 31, 2006 the variable rate portion of the commercial and commercial mortgage portfolio had decreased to 42% from 62% at year-end 2005, impacting Merchants' ability to take advantage of rising short-term rates during 2006. Additionally, of the $82.72 million of Merchants' capped commercial loans and capped commercial mortgages, $51.65 million reached their caps. Average interest bearing deposits grew $10.93 million during 2006. Following national trends, balances continued to shift from lower cost money market and other transaction accounts to time deposits. Time deposits at December 31, 2006 made up 36% of total deposits compared to 29% of total deposits at December 31, 2005. Merchants' deposit growth during 2006 was concentrated in its short-term CD specials, which have an average cost at year end of approximately 4.67%. Merchants faced aggressive competition from other banks in the marketplace to raise rates on deposits, particularly in the time deposit area. Merchants also had success with its new overnight cash management sweep program during the year. The product is secured by an overnight repurchase agreement, and is priced favorably when compared to comparable short-term Federal Home Loan Bank of Boston ("FHLB") borrowings. Year-end 2006 balances in this product were $86.55 million.

 

Merchants closed its private placement of an aggregate of $20 million of trust preferred securities on December 15, 2004. The securities bear interest for five years at a fixed rate of 5.95%, and after five years, the rate adjusts quarterly at a fixed spread over three month LIBOR. The impact on net interest income for 2007 and 2006 from the additional interest expense was $1.19 million per year.

 

The following table presents the condensed annual average balance sheets for 2007, 2006 and 2005. The total dollar amount of interest income from assets and the related yields are calculated on a taxable equivalent basis:

<PAGE>  20

Merchants Bancshares, Inc.
Distribution of Assets, Liabilities and Shareholders' Equity; Interest Rates and Net Interest Margin

 
 

2007

 

2006

 

2005


Taxable Equivalent
(In thousands)

Average
Balance

 

Interest
Income/
Expense

 

Average
Yield/
Rate

 

Average
Balance

 

Interest
Income/
Expense

 

Average
Yield/
Rate

 

Average
Balance

 

Interest
Income/
Expense

 

Average
Yield/
Rate


ASSETS:

                                 

Investment securities: (a)

                                 

    U.S. Treasury and Agencies

$142,370 

 

$  7,087 

 

4.98%

 

$   162,029 

 

$  7,790 

 

4.81%

 

$   152,751 

 

$  6,979 

 

4.57%

    Other, including FHLB Stock

183,490 

 

8,361 

 

4.56%

 

232,582 

 

10,407 

 

4.47%

 

247,517 

 

10,182 

 

4.11%


            Total investment securities

325,860 

 

15,448 

 

4.74%

 

394,611 

 

18,197 

 

4.61%

 

400,268 

 

17,161 

 

4.29%


                                   

Loans, including fees on loans:

                                 

    Commercial

86,237 

 

6,553 

 

7.60%

 

80,620 

 

6,161 

 

7.64%

 

85,795 

 

5,768 

 

6.72%

    Real Estate

619,290 

 

40,287 

 

6.51%

 

560,942 

 

36,877 

 

6.57%

 

496,134 

 

30,484 

 

6.14%

    Consumer

7,592 

 

498 

 

6.56%

 

7,151 

 

439 

 

6.13%

 

7,479 

 

403 

 

5.39%


            Total loans (b) (c)

713,119 

 

47,338 

 

6.64%

 

648,713 

 

43,477 

 

6.70%

 

589,408 

 

36,655 

 

6.22%


                                   

Federal funds sold, securities sold
  under agreements to repurchase and
  interest bearing deposits with banks

36,388 

 

1,882 

 

5.17%

 

6,799 

 

354 

 

5.21%

 

819 

 

21 

 

2.61%


            Total earning assets

1,075,367 

 

64,668 

 

6.01%

 

1,050,123 

 

62,028 

 

5.91%

 

990,495 

 

53,837 

 

5.44%


                                   

Allowance for loan losses

(7,275)

         

(6,840)

         

(7,391)

       

Cash and cash equivalents

34,969 

         

35,750 

         

38,139 

       

Premises and equipment

11,945 

         

12,280 

         

12,418 

       

Other assets

16,582 

         

19,388 

         

20,200 

       


            Total assets

$1,131,588 

         

$1,110,701 

         

$1,053,861 

       


                                   

LIABILITIES AND SHAREHOLDERS' EQUITY:

                                 

Interest bearing deposits:

                                 

    Savings, Money market & NOW Accounts

$   425,325 

 

$  4,779 

 

1.12%

 

$   458,337 

 

$  5,191 

 

1.13%

 

$   505,303 

 

$  3,940 

 

0.78%

    Time deposits

325,940 

 

13,181 

 

4.04%

 

278,085 

 

9,478 

 

3.41%

 

220,190 

 

5,061 

 

2.30%


            Total interest bearing deposits

751,265 

 

17,960 

 

2.39%

 

736,422 

 

14,669 

 

1.99%

 

725,493 

 

9,001 

 

1.24%


                                   

Federal Home Loan Bank short-term
  borrowings

-- 

 

-- 

 

-- 

 

43,911 

 

2,142 

 

4.88%

 

44,278 

 

1,482 

 

3.35%

Securities sold under agreements to
  repurchase and other short-term debt

85,041 

 

3,503 

 

4.12%

 

43,318 

 

1,918 

 

4.43%

 

1,137 

 

35 

 

3.08%

Securities sold under agreements to
  repurchase, long-term

23,944 

1,326 

5.54%

20,000 

1,106 

5.53%

214 

11 

5.15%

Other long-term debt

50,719 

 

2,407 

 

4.75%

 

53,397 

 

2,264 

 

4.24%

 

70,599 

 

2,155 

 

3.05%

Junior subordinated debentures
  issued to unconsolidated
  subsidiary trust

20,619 

 

1,190 

 

5.77%

 

20,619 

 

1,190 

 

5.77%

 

20,619 

 

1,190 

 

5.77%


            Total interest bearing liabilities

931,588 

 

26,386 

 

2.83%

 

917,667 

 

23,289 

 

2.54%

 

862,340 

 

13,874 

 

1.61%


                                   

Demand deposits

122,409 

         

120,600 

         

118,459 

       

Other liabilities

6,930 

         

5,475 

         

7,883 

       

Shareholders' equity

70,661 

         

66,959 

         

65,179 

       


            Total liabilities &
              shareholders' equity

$1,131,588 

         

$1,110,701 

         

$1,053,861 

       


                                   

Net interest income (b)

   

$38,282 

         

$38,739 

         

$  39,963 

   


Tax equivalent adjustment

   

(69)

         

(31)

         

(28)

   


Net interest income per book

   

$38,213 

         

$38,708 

         

$  39,935 

   


                                   

Yield spread

       

3.18%

         

3.37%

         

3.83%


Net interest margin (b)

       

3.56%

         

3.69%

         

4.03%


 

(a)

Available for sale securities are included at fair value, held to maturity securities are included at amortized cost.

(b)

Tax exempt interest has been converted to a tax equivalent basis using the Federal tax rate of 35%.

(c)

Includes principal balance of non-accrual loans and fees on loans.

<PAGE>  21

The following table presents the extent to which changes in interest rates and changes in the volume of earning assets and interest bearing liabilities have affected interest income and interest expense during the periods indicated. Information is presented in each category with respect to: (i) changes attributable to changes in volume (changes in volume multiplied by prior rate), (ii) changes attributable to changes in rate (changes in rate multiplied by prior volume) and (iii) changes in volume/rate (change in volume multiplied by change in rate).

 

Merchants Bancshares, Inc.

Analysis of Changes in Fully Taxable Equivalent Net Interest Income

 

 

2007 vs 2006


       

Due to

       


(In thousands)

2007

2006

Increase
(Decrease)

Volume

Rate

Volume/
Rate


Fully taxable equivalent interest income:

           

    Loans

$47,338

$43,477

$ 3,861 

$ 4,317 

$   (414)

$  (42)

    Investments

15,448

18,197

(2,749)

(3,170)

510 

(89)

    Federal funds sold, securities sold under
      agreements to repurchase and interest
      bearing deposits with banks

1,882

354

1,528 

1,541 

(2)

(11)


            Total interest income

64,668

62,028

2,640 

2,688 

94 

(142)


Less interest expense:

           

    Savings, Money market & NOW accounts

4,779

5,191

(412)

(374)

(41)

    Time deposits

13,181

9,478

3,703 

1,631 

1,768 

304 

    Federal Home Loan Bank short-term
      borrowings

--

2,142

(2,142)

(2,142)

-- 

-- 

    Securities sold under agreements to
      repurchase and other short-term debt

3,503

1,918

1,585 

1,848 

(135)

(128)

    Securities sold under agreements to
      repurchase, long-term

1,326

1,106

220 

219 

-- 

    Other long-term debt

2,407

2,264

143 

(113)

270 

(14)

    Junior subordinated debentures issued to
      unconsolidated subsidiary trust

1,190

1,190

-- 

-- 

-- 

-- 


            Total interest expense

26,386

23,289

3,097 

1,069 

1,863 

165 


            Net interest income

$38,282

$38,739

$   (457)

$ 1,619 

$(1,769)

$(307)


 
 

2006 vs 2005


       

Due to

       


(In thousands)

2006

2005

Increase
(Decrease)

Volume

Rate

Volume/
Rate


Fully taxable equivalent interest income:

           

    Loans

$43,477

$36,655

$ 6,822 

$3,687 

$ 2,848 

$ 287 

    Investments

18,197

17,161

1,036 

(243)

1,297 

(18)

    Federal funds sold, securities sold under
      agreements to repurchase and interest
      bearing deposits with banks

354

21

333 

156 

21 

156 


            Total interest income

62,028

53,837

8,191 

3,600 

4,166 

425 


Less interest expense:

           

    Savings, Money market & NOW accounts

5,191

3,940

1,251 

(366)

1,783 

(166)

    Time deposits

9,478

5,061

4,417 

1,331 

2,444 

642 

    Federal Home Loan Bank short-term
      borrowings

2,142

1,482

660 

(12)

677 

(5)

    Securities sold under agreements to
      repurchase and other short-term debt

1,918

35

1,883 

1,299 

15 

569 

    Securities sold under agreements to
      repurchase, long-term

1,106

11

1,095 

1,019 

75 

    Other long-term debt

2,264

2,155

109 

(525)

839 

(205)

    Junior subordinated debentures issued to
      unconsolidated subsidiary trust

1,190

1,190

-- 

-- 

-- 

-- 


            Total interest expense

23,289

13,874

9,415 

2,746 

5,759 

910 


            Net interest income

$38,739

$39,963

$(1,224)

$   854 

$(1,593)

$(485)


<PAGE>  22

Provision for Credit Losses

Merchants recorded a provision expense of $1.15 million during 2007 as a result of overall portfolio growth, an increase in internally criticized loans and the need to provide prudent and reasonable allowances for a large, non-performing residential construction project. No provision for credit losses was recorded during 2006, 2005 or 2004 primarily due to continued strong asset quality and low loss levels. Merchants experienced net charge offs of $81 thousand during 2007 and net recoveries of $198 thousand during 2006. The Allowance is comprised of the allowance for loan losses and the reserve for undisbursed lines of credit. At December 31, 2007 the allowance for loan losses was $8.00 million, 1.09% of total loans and 87% of nonperforming loans, compared to $6.91 million, 1.00% of total loans and 256% of nonperforming loans at December 31, 2006. All of these factors are taken into consideration during management's quarterly review of the Allowance which management continues to deem adequate under current market conditions. For a more detailed discussion of Merchants' Allowance and nonperforming assets, see "Credit Quality and Allowance for Credit Losses."

 

NONINTEREST INCOME AND EXPENSES

 

Noninterest income

 

2007 compared to 2006

Merchants' noninterest income increased $1.15 million to $9.34 million for 2007 compared to $8.19 million for 2006. Merchants sold an investment in a real estate limited partnership during the fourth quarter of 2007 and recognized a gain in the amount of approximately $260 thousand; the gain is reflected as a reduction in equity in losses of real estate limited partnerships. Excluding this gain and excluding losses on investment securities of $97 thousand for 2007 and $464 thousand for 2006, noninterest income increased $529 thousand when comparing 2007 to 2006. Trust company revenue increased $194 thousand to $1.96 million for 2007 from $1.76 million for 2006, an 11.0% increase, as Merchants continued to increase overall relationships during the year. Service charges on deposits increased by $198 thousand, primarily a result of continued increases in overdraft fees. The category Other noninterest income increased $346 thousand for 2007 compared to 2006, primarily a result of increased net debit card revenue.

 

Merchants' equity in losses of real estate limited partnerships was slightly lower at $1.48 million for 2007, compared to $1.54 million for 2006. As mentioned above, Merchants recognized a gain of approximately $260 thousand during 2007 on the sale of a partnership which reduced this contra income item. Additionally, during 2006 Merchants sold its interest in two of these partnerships and recognized a gain of $156 thousand which reduced this contra income item. Excluding these transactions Merchants equity in losses of real estate limited partnerships increased by $53 thousand for 2007 compared to 2006. Merchants accounts for its investment in these partnerships using the equity method. Losses generated by the partnerships are recorded as a reduction in Merchants' investments in the Consolidated Balance Sheets and as a reduction of noninterest income in the Consolidated Statements of Income. Tax credits generated by the partnerships are recorded as a reduction in the income tax provision. Merchants finds these investments attractive because they provide a high targeted internal rate of return, and provide an opportunity to invest in affordable housing in the communities in which Merchants does business.

 

2006 compared to 2005

Total noninterest income increased $388 thousand to $8.19 million for 2006 from $7.80 million for 2005. Losses recognized on investment securities totaled $464 thousand for 2006, compared to $32 thousand for 2005. Excluding losses on investments, total noninterest income increased $820 thousand year-over-year. Trust company income was $111 thousand higher for 2006 than 2005, a result of overall growth in relationships and market gains during 2006. The category Service Charges on Deposits increased $291 thousand for 2006 compared to 2005. This increase was primarily a result of increased overdraft service charges during 2006. These increased overdraft charges were partially offset by decreased monthly checking service charges. Additionally, cash management sweep fees decreased during 2006. Merchants began directing its cash management sweep balances to its new repurchase program during 2006 resulting in decreases in cash management sweep fees received from that external provider. Additionally, Merchants reduced the sweep fee charged to its customers to a more competitive level. Merchants equity in losses of real estate limited partnerships decreased $177 thousand for 2006 compared to 2005. Merchants sold its interest in two of these partnerships and received cash distributions of $156 thousand which reduced this contra income item. Other noninterest income increased $241 thousand for 2006 compared to 2005, primarily a result of increases in Merchants' net ATM and debit card revenue. Merchants' growth in transaction accounts and high retention rate of existing accounts has been a key contributor to these increases. These categories continued to increase during 2006 when compared to 2005, but at a slower pace.

<PAGE>  23

Noninterest expense

 

2007 compared to 2006

Merchants continued to focus on expense control during 2007; total noninterest expenses decreased by $436 thousand, when comparing 2007 to 2006. Employee benefits decreased by $502 thousand when comparing 2007 to 2006, this decrease is primarily a result of a reduction in Merchants' employer match for its 401(k) plan for 2007. Merchants' marketing expense for 2007 decreased $256 thousand, due to the timing of certain promotions. Merchants' expenses related to OREO increased during 2007 as OREO balances grew to $475 thousand at year end.

 

2006 compared to 2005

Total noninterest expense increased by $642 thousand, or 2.00%, to $32.72 million for 2006 from $32.08 million for 2005. Salaries and wages decreased slightly from 2005 to 2006. This change was the result of a high number of vacant positions during the first half of 2006, the outsourcing of the item processing function during mid-2005 and decreases in estimated incentive payouts as a result of decreased profitability. These factors helped to offset the effect of normal salary increases. Included in 2006 salaries is staffing related to Merchants' newest full service branch in Waterbury, VT which opened in late September 2006. Employee benefits expense increased $301 thousand for the full year 2006 compared to 2005, primarily a result of increased pension expenses for 2006. Merchants' health and group insurance expense increased 10% over 2005. Merchants transitioned to a high deductible, consumer driven health plan starting at the beginning of 2006 to help manage its future health care cost increases.

 

Legal and professional fees were $2.43 million for 2006, a $320 thousand increase over 2005. The outsourcing of the item processing function mentioned previously resulted in decreases in salaries and benefits, as well as occupancy and equipment expenses, and resulted in an increase in professional fees.

 

Income Taxes

Merchants recognized $1.65 million, $1.65 million and $1.70 million, respectively, during 2007, 2006 and 2005 in low-income housing tax credits as a reduction in the provision for income taxes; this resulted in an effective tax rate of 23.1%, 23.3%, and 24.0% for 2007, 2006 and 2005, respectively. As of December 31, 2007, Merchants has a net deferred tax liability of approximately $747 thousand arising from temporary differences between Merchants' book and tax reporting. This net deferred tax liability is included in Other liabilities in the Consolidated Balance Sheets.

 

BALANCE SHEET ANALYSIS

 

Merchants' year-end total assets increased $33.79 million, or 3.0%, to $1.17 billion from $1.14 billion during 2007, while Merchants' average earning assets increased by $25.24 million, or 2.4%, to $1.08 billion for the year ended December 31, 2007 from $1.05 billion in December 31, 2006.

 

Loans

Merchants has continued to shift earning assets from the investment portfolio to the loan portfolio during 2007. Loans made up 63.5% of earning assets at year end 2007, compared to 61.9% of earning assets at year end 2006. This shift in the make up of the balance sheet carries with it some amount of increased risk, as loans have a higher risk profile than investments, but also have a higher average yield. Total loans increased $42.23 million, or 6.1%, to $731.51 million at December 31, 2007 from $689.28 million at December 31, 2006. The composition of Merchants' loan portfolio is shown in the following table:

 
   

As of December 31,

 
 

Type of Loan

2007

 

2006

 

2005

 

2004

 

2003

 
 


 
   

(In thousands)

 
 

Commercial, Financial &

                   
 

  Agricultural

$  92,740

 

$  73,512

 

$  71,912

 

$  82,644

 

$  84,698

 
 

Real Estate - Residential

356,472

 

323,885

 

293,158

 

265,306

 

263,538

 
 

Real Estate - Commercial

234,675

 

250,526

 

208,049

 

209,333

 

200,494

 
 

Real Estate - Construction

39,347

 

33,167

 

25,942

 

19,354

 

12,536

 
 

Installment

7,220

 

7,133

 

6,345

 

7,016

 

6,726

 
 

All Other Loans

1,054

 

1,060

 

520

 

679

 

1,005

 
 


 
   

$731,508

 

$689,283

 

$605,926

 

$584,332

 

$568,997

 
 


 
 
 

Totals above are shown net of deferred loans fees of $22 thousand, $95 thousand, $275 thousand, $497 thousand and $675 thousand for 2007, 2006, 2005, 2004, and 2003, respectively.

 

<PAGE>  24

The majority of loan growth occurred in residential real estate and commercial loans. Residential real estate loans grew $32.59 million, or 10.06%, during 2007 as borrowers continued to take advantage of attractive long term interest rates. Commercial loans grew $19.23 million, or 26.16% during the year. This growth was related primarily to sustained new business calling efforts. Additionally, Merchants' position as the sole remaining state wide independent banking company appealed to a segment of the market. Several customers cited the local management and decision-making as important considerations when choosing a bank. Commercial real estate loans declined by 6.33%, or $15.85 million during 2007; these balances were impacted by the sale of several properties that secure large lending relationships.

 

Balances of real estate construction loans increased to $39.35 million at December 31, 2007 from $33.17 million at December 31, 2006. For approximately $25 million of the outstanding construction loans at December 31, 2007, the primary source of repayment will be the sale of residential housing units. Included in this amount is the $6.70 million nonaccrual relationship described previously. Approximately $7.5 million of the remaining $14 million is attributable to construction of multi-family housing and will be repaid upon conversion to term financing from future rental income. The balance of approximately $6 million consists of loans to commercial and investment real estate borrowers. These loans will generally be repaid from conversion to term financing.

 

At December 31, 2007, Merchants serviced $4.65 million in residential mortgage loans for investors such as Federal government agencies (FNMA and FHLMC) and other financial investors. This servicing portfolio has decreased significantly as Merchants no longer sells its residential mortgages on the secondary market. Servicing revenue is not expected to be a significant revenue source in the future.

 

The following table presents the distribution of the varying contractual maturities of the loan portfolio at December 31, 2007:

 

 

Type of Loan

 

One Year
Or Less

 

Over One
Through
5 Years

 

Over Five
Years

 

Total

 
 


 
     

(In thousands)

 
 

Commercial Financial &

                 
 

  Agricultural

 

$  40,177

 

$  33,753

 

$  18,810

 

$  92,740

 
 

Real Estate - Residential

 

9,230

 

66,722

 

280,520

 

356,472

 
 

Real Estate - Commercial

 

24,244

 

116,798

 

93,633

 

234,675

 
 

Real Estate - Construction

 

35,077

 

3,818

 

452

 

39,347

 
 

Installment

 

5,089

 

2,093

 

38

 

7,220

 
 

All Other

 

1,052

 

--

 

2

 

1,054

 
 


 
     

$114,869

 

$223,184

 

$393,455

 

$731,508

 
 


 
 

Loans maturing after one year which have predetermined interest rates totaled $545.23 million. Loans maturing after one year which have floating or adjustable interest rates totaled $71.41 million.

<PAGE>  25

Investments

The investment portfolio is used to generate interest income, manage liquidity and mitigate interest rate sensitivity. The composition of Merchants' investment portfolio at carrying amounts is shown in the following table:

   
 

As of December 31,


 

2007

 

2006

 

2005


Available for Sale:

(In thousands)

U.S. Treasury Obligations

$       255

 

$       199

 

$       198

U.S. Agency Obligations

15,840

 

21,759

 

14,819

Residential Real Estate Mortgage-backed securities

164,564

 

120,466

 

133,425

Commercial Real Estate Mortgage-backed securities

36,083

 

47,566

 

66,235

Collateralized Mortgage Obligations

122,137

 

109,320

 

131,969

Corporate Bonds

14,316

 

22,809

 

23,346

Asset Backed Securities

8,317

 

11,839

 

12,805


            Total available for sale

361,512

 

333,958

 

382,797


Held to maturity:

         

Residential Real Estate Mortgage-backed securities

4,078

 

5,615

 

7,663


            Total held to maturity

4,078

 

5,615

 

7,663


Total Securities

$365,590

 

$339,573

 

$390,460


 

Merchants' year-end investment portfolio increased $26.02 million from 2006 to 2007. Merchants allowed its investment portfolio to run off for the first half of 2007 as the flat yield curve provided little opportunity to earn an acceptable spread on continued investments. Merchants took advantage of the steepening yield curve toward the end of 2007 and began redeploying funds into the portfolio during the latter part of 2007. Merchants increased the portfolio by $62.86 million during the fourth quarter of 2007. $43.50 million of these investments were funded by a mix of Federal Home Loan Bank borrowings and structured repurchase agreements. The balance was funded by cash flow from the loan portfolio, deposit cash flows and growth in customer repurchase agreements. The average spread earned on the leveraged investment trades was approximately 130 basis points. Low yielding securities with an amortized cost of $5.47 million were sold during 2007. Merchants recognized a loss on these securities in its statement of income during 2007 of $97 thousand. Additionally, after the extraordinary interest rate decreases by the Federal Reserve Board in early 2008 Merchants was able to take advantage of the steepened yield curve and market conditions to sell lower yielding securities and redeployed the funds into higher credit, longer maturity assets. Merchants sold securities with an amortized cost of $26.93 million during January of 2008 at a net pre-tax gain of $82 thousand. Merchants sold its entire corporate bond portfolio, several of its commercial mortgage backed securities and one agency security.

 

The contractual final maturity distribution of the debt securities classified as available for sale and held to maturity as of December 31, 2007, are as follows:

 

SECURITIES AVAILABLE FOR SALE:

 

(In thousands)

Within
One Year

 

After One
But Within
Five Years

 

After Five
But Within
Ten Years

 

After Ten
Years

 

Total


U.S. Treasury Obligations

$       --

 

$     255

 

$         --

 

$           --

 

$       255

U.S. Agency Obligations

4,022

 

11,818

 

--

 

--

 

15,840

Residential Real Estate
  Mortgage-backed Securities

2,012

 

19,694

 

39,580

 

103,278

 

164,564

Commercial Real Estate
  Mortgage-backed Securities

--

 

1,881

 

--

 

34,202

 

36,083

Collateralized Mortgage
  Obligations

--

 

5,337

 

14,170

 

102,630

 

122,137

Corporate Bonds

3,249

 

8,638

 

2,429

 

--

 

14,316

Asset Backed Securities

--

 

2,493

 

--

 

5,824

 

8,317


 

$9,283

 

$50,116

 

$56,179

 

$245,934

 

$361,512


Weighted average investment
  yield

4.15%

 

4.41%

 

4.68%

 

4.98%

 

4.84%


<PAGE>  26

SECURITIES HELD TO MATURITY

 

(In thousands)

Within
One Year

 

After One
But Within
Five Years

 

After Five
But Within
Ten Years

 

After Ten
Years

 

Total


Residential Real Estate
  Mortgage-backed Securities

$    23

 

$    864

 

$2,244

 

$    947

 

$4,078


Weighted average investment
  yield

5.59%

 

6.34%

 

6.97%

 

6.47%

 

6.71%


 

Actual maturities will differ from contractual maturities because borrowers may have rights to call or prepay obligations. Maturities of mortgage-backed securities and collateralized mortgage obligations are based on final contractual maturities.

 

Other Assets

Bank Premises and Equipment decreased to $11.48 million at year-end 2007 from $12.54 million at year-end 2006 as Merchants' fixed asset depreciation exceeded fixed asset purchases. Investments in Real Estate Limited Partnerships decreased $1.71 million primarily as a result of amortization of the investments and the previously mentioned sale of an investment in a limited partnership. These partnerships provide affordable housing in the communities in which Merchants does business, and provide Merchants with an acceptable level of return on its investment.

 

Deposits

Merchants' year-end deposit balances decreased $9.92 million to $867.44 million at year-end 2007 from $877.35 million at year-end 2006. The composition of Merchants' deposit balances is shown in the following table:

 
   

As of December 31,

 
 

Type of Deposit

2007

 

2006

 

2005

 
 


 
   

(In thousands)

 
 

Demand

$123,344

 

$122,036

 

$124,292

 
 

Free Checking for Life®

178,829

 

182,395

 

181,415

 
 

Other Savings and NOW

39,149

 

49,681

 

50,196

 
 

Money Market Accounts

193,343

 

210,366

 

248,344

 
 

Time Deposits

332,772

 

312,874

 

250,329

 
 


 
   

$867,437

 

$877,352

 

$854,576

 
 


 
               

Merchants continues to expand its presence with households, small businesses, and corporate clients. Numbers of accounts increased in all deposit categories. The rate of new account growth was affected by new competition entering a number of relatively mature markets. Although 2007 ending deposit balances were $9.92 million lower than 2006 ending deposit balances, total average deposits for the year were $873.67 million, a $16.65 million increase over the 2006 average of $857.02 million. The mix of deposit dollars continued to shift within deposit categories during 2007. Money flowed from checking, savings, and money market accounts, which decreased $29.81 million from December 31, 2006 to December 31, 2007, into certificates of deposit as depositors sought attractive yields for discretionary funds. Time deposit balances increased $19.90 million during 2007. The rate of the migration from money market categories to time deposits generally slowed during the first half of 2007, but started to increase again during the second half of the year as short-term interest rates moved lower.

 

Time Deposits of $100 thousand and greater at December 31, 2007 had the following schedule of maturities:

 

 

(In thousands)

     
 


 
 

Three Months or Less

 

$21,606

 
 

Three to Six Months

 

23,311

 
 

Six to Twelve Months

 

37,685

 
 

One to Five Years

 

3,136

 
 


 
     

$85,738

 
 


 

<PAGE>  27

Other Liabilities

Merchants continues to see success with its cash management sweep product which is priced at a lower cost of funds than other short-term borrowing alternatives. Balances in this product totaled $96.75 million at December 31, 2007, a $10.2 million increase over December 31, 2006 balance of $86.55 million. The balances are included with "Securities sold under agreements to repurchase and other short-term borrowings" on the accompanying consolidated balance sheet. Merchants' other long-term debt position increased to $62.12 million at December 31, 2007 from $53.86 million at December 31, 2006. As mentioned previously, Merchants entered into a leveraged investment trade during the fourth quarter of 2007. Merchants borrowed $43.50 million during the fourth quarter of the year in a mix of bullet and amortizing Federal Home Loan Bank ("FHLB") advances, as well as structured repurchase agreements. The structured repurchase agreements have a five year final maturity, bear interest at an average rate of 4.23%, and are callable in two years. The cost of this funding will be reduced by the cash flows of embedded interest rate caps that will provide additional protection if rates start to move up. The caps come into the money when three month LIBOR reaches rates ranging from 5.07% to 5.62%. Merchants borrowed $20 million under a structured repurchase agreement during December 2005 that matures in December 2008. This borrowing is capped to protect against rising rates, and the cost of the funding will be reduced by the cash flows of an embedded floor if rates start to fall. The floor comes into the money if the three month London Interbank Offering Rate ("LIBOR") falls below 4%. Three month LIBOR was 4.68% at December 31, 2007.

 

On December 15, 2004 Merchants closed its private placement of an aggregate of $20 million of trust preferred securities. The placement occurred through a newly formed Delaware statutory trust affiliate of Merchants, MBVT Statutory Trust I (the "Trust") as part of a pooled trust preferred program. The Trust was formed for the sole purpose of issuing capital securities; these securities are non-voting. Merchants owns all of the common securities of the Trust. The proceeds from the sale of the capital securities were loaned to Merchants under deeply subordinated debentures issued to the Trust. The debentures are the only asset of the Trust and payments under the debentures are the sole revenue of the Trust. Merchants' primary source of funds to pay interest on the debentures held by the Trust is current dividends from its principal subsidiary, Merchants Bank. Accordingly, Merchants' ability to service the debentures is dependent upon the continued ability of Merchants Bank to pay dividends to Merchants.

 

These hybrid securities qualify as regulatory capital for Merchants, up to certain regulatory limits. At the same time they are considered debt for tax purposes, and as such, interest payments are fully deductible. The trust preferred securities bear interest for five years at a fixed rate of 5.95%, and after five years, the rate adjusts quarterly at a fixed spread over three month LIBOR. The trust preferred securities mature on December 31, 2034, and are redeemable without penalty at Merchants' option, subject to prior approval by the Federal Reserve, beginning after five years from issuance. The proceeds from the sale of the trust preferred securities were used for general corporate purposes, allowing Merchants to pay the special dividend declared on December 1, 2004 and at the same time continue to pursue alternative growth opportunities.

 

CREDIT QUALITY AND ALLOWANCE FOR CREDIT LOSSES

 

Stringent credit quality is a major strategic focus of Merchants. Although Merchants is actively managing current nonperforming and classified loans, there is no assurance that Merchants will not have increased levels of problem assets in the future. The make up of the nonperforming pool is dynamic with accounts moving in and out of this category during the course of a quarter. The following table summarizes Merchants' nonperforming loans ("NPL") and nonperforming assets ("NPA") as of December 31, 2003, through December 31, 2007:

 

(In thousands)

 

2007

 

2006

 

2005

 

2004

 

2003


Nonaccrual loans

 

$9,018

 

$2,606

 

$2,284

 

$3,233

 

$2,100

Loans past due 90 days or more and still accruing

 

57

 

--

 

--

 

20

 

26

Troubled debt restructurings

 

156

 

92

 

80

 

83

 

86


            Total nonperforming loans

 

9,231

 

2,698

 

2,364

 

3,336

 

2,212


Other real estate owned ("OREO")

 

475

 

258

 

--

 

--

 

--


            Total nonperforming assets

 

$9,706

 

$2,956

 

$2,364

 

$3,336

 

$2,212


<PAGE>  28

Nonperforming loans increased to $9.23 million at December 31, 2007 from $2.70 million at December 31, 2006. The increase is primarily attributable to $6.7 million in loans related to a residential condominium construction project that were moved to non-accrual status during the third quarter of 2007. Cost overruns on site work and infrastructure and slow unit sales reflecting the weakening housing market have strained the borrower's ability to fund its share of construction costs and service the loans. Subsequent to December 31, 2007, Merchants received payments of $2.24 million primarily as part of a re-capitalization of the project related to this non-accrual relationship. The borrower is continuing efforts to sell completed units in the property.

 

Merchants had two properties with a value of $475 thousand held as OREO at December 31, 2007, compared to one property with a value of $258 thousand held as OREO at December 31, 2006. Both properties were sold at auction in early 2008 at values adequate to cover the book balance and recoup some expenses related to the sales.

 

Merchants' policy is to classify a loan 90 days or more past due with respect to principal or interest as a nonaccruing loan, unless the ultimate collectibility of principal and interest is assured. Income accruals are suspended on all nonaccruing loans, and all previously accrued and uncollected interest is typically charged against current income. A loan remains in nonaccruing status until the factors which suggest doubtful collectibility no longer exist, the loan is liquidated, or when the loan is determined to be uncollectible, and is charged off against the allowance for loan losses. In those cases where a nonaccruing loan is secured by real estate, Merchants can, and may, initiate foreclosure proceedings. The result of such action will either be to cause repayment of the loan with the proceeds of a foreclosure sale or to give Merchants possession of the collateral in order to manage a future resale of the real estate. Foreclosed property is recorded at the lower of its cost or estimated fair value, less any estimated costs to sell. Any cost in excess of the estimated fair value on the transfer date is charged to the allowance for loan losses, while further declines in market values are recorded as OREO expense in the consolidated statement of income.

 

Management maintains an internal listing of all criticized and classified loans. The list is reviewed and updated monthly. The list make-up is dynamic with individual loans migrating off and on the list. Some of these loans may migrate to non-performing status during the course of the next twelve months. Management believes that classified loans have well-defined weaknesses which, if left unattended, could lead to collection problems. The oversight process on these loans includes an active risk management approach. A management committee reviews the status of these loans each quarter and determines or confirms the appropriate risk rating, probable loss exposure (if any) and accrual status. The findings of this review process are instrumental in determining the adequacy of the Allowance. Excluded from nonperforming loans are approximately $19.6 million of internally classified loans at December 31, 2007 compared to $5.5 million at December 31, 2006. Included in internally classified loans at December 31, 2007 are $4.9 million in owner-occupied commercial real estate and commercial loans to a residential home builder. No other internally classified loans are tied to the housing or any other specific industry. Approximately $3.3 million is attributable to commercial borrowers in a variety of industries, $3.7 million to non-owner occupied real estate and $7.7 million to owner-occupied real estate. To date all payments have been made as agreed by these customers and Merchants appears adequately secured. Merchants' management will continue to closely monitor asset quality.

 

Merchants performs detailed and extensive reviews on larger credits and problematic credits identified on the watched asset list, nonperforming asset listings and internal credit rating reports. A loan is considered impaired when it is probable that Merchants will be unable to collect all principal and interest due according to the contractual terms of the loan agreement. This treatment does not apply to large groups of smaller-balance homogenous loans that are collectively evaluated for impairment, such as residential mortgage and consumer loans. When a loan is impaired, Merchants measures an impairment loss equal to the excess, if any, of the loan's carrying amount over (1) the present value of expected future cash flows discounted at the loan's original effective interest rate, (2) the observable market price of the impaired loan, or (3) the fair value of the collateral securing a collateral-dependent loan. When a loan is deemed to have an impairment loss, a valuation allowance is established as part of the overall allowance for loan losses. The bank recognizes interest income on impaired loans consistent with its nonaccrual policy for loans generally. Loans continue to be classified as impaired unless they are brought fully current and the collection of scheduled interest and principal is considered probable. Impaired loans totaled $8.87 million and $2.29 million at December 31, 2007 and 2006, respectively, and are included as nonaccrual loans in the table above.

<PAGE>  29

The allowance for loan losses is based on Management's estimate of the amount required to reflect the known and inherent risks in the loan portfolio, based on circumstances and conditions known at each reporting date. Merchants reviews the adequacy of the allowance for loan losses quarterly. Factors considered in evaluating the adequacy of the allowance for loan losses include previous loss experience, the size and composition of the portfolio, risk rating composition, current economic and real estate market conditions and their effect on the borrowers, the performance of individual loans in relation to contract terms and estimated fair values of properties that secure impaired loans.

 

The adequacy of the allowance for loan losses is determined using a consistent, systematic methodology, consisting of a review of the following key elements:

 

A specific reserve for loans identified as impaired;

A general reserve for the various loan portfolio classifications.

 

The general allowance for loan losses is a percentage-based reflection of historical loss experience and assigns a required allocation by loan classification based on a fixed percentage of all outstanding loan balances. The general allowance for loan losses employs a risk-rating model that grades loans based on their general characteristics of credit quality and relative risk. For pass rated loans, appropriate levels are estimated based on management's judgments regarding the historical loss experience, current economic trends, trends in the portfolio mix, volume and trends in delinquencies and non-accrual loans.

 

The following table summarizes the allowance for loan losses allocated by loan type:

 

(In thousands)

 

2007

 

2006

 

2005

 

2004

 

2003


Commercial Financial & Agricultural

 

$1,843

 

$1,236

 

$1,339

 

$1,658

 

$2,144

Real Estate - Residential

 

775

 

687

 

586

 

636

 

545

Real Estate - Commercial

 

4,204

 

4,567

 

2,066

 

2,686

 

3,809

Real Estate - Construction

 

1,070

 

332

 

431

 

187

 

161

Installment

 

4

 

4

 

13

 

16

 

27

All other Loans

 

106

 

85

 

113

 

365

 

367

Unallocated Allowance

 

--

 

--

 

2,535

 

1,964

 

901


Allowance for Loan Losses

 

$8,002

 

$6,911

 

$7,083

 

$7,512

 

$7,954


 

Prior to 2006, the unallocated allowance for loan losses was maintained for certain risk factors that were inherent in Merchants' commercial portfolios. As such, that portion of the allowance was allocated to the commercial loan and commercial real estate portfolios during 2006 and 2007. Losses are charged against the Allowance when management believes that the collectibility of principal is doubtful. To the extent management determines the level of anticipated losses in the portfolio has significantly increased or diminished, the Allowance is adjusted through current earnings. Overall, management believes that the Allowance is maintained at an adequate level, in light of historical and current factors, to reflect the level of credit risk in the loan portfolio. Loan loss experience and nonperforming asset data are presented and discussed in relation to their impact on the adequacy of the Allowance.

<PAGE>  30

The following table reflects Merchants' loan loss experience and activity in the Allowance for the past five years.

 

(In thousands)

 

2007

 

2006

 

2005

 

2004

 

2003


Average Loans Outstanding

 

$713,119 

 

$648,713 

 

$589,408 

 

$581,259 

 

$536,095 

Allowance Beginning of Year

 

7,281 

 

7,083 

 

7,512 

 

7,954 

 

8,497 

Charge-offs:

                   

    Commercial, Lease Financing
      and all Other Loans

 

(170)

 

(46)

 

(336)

 

(56)

 

(722)

    Real Estate - Mortgage

 

(242)

 

(13)

 

(339)

 

(703)

 

(343)

    Installment & Credit Cards

 

(20)

 

(4)

 

(18)

 

(17)

 

(17)


            Total Charge-offs

 

(432)

 

(63)

 

(693)

 

(776)

 

(1,082)


Recoveries:

                   

    Commercial, Lease Financing
      and all Other Loans

 

271 

 

236 

 

144 

 

34 

 

397 

    Real Estate - Construction

 

-- 

 

-- 

 

-- 

 

-- 

 

-- 

    Real Estate - Mortgage

 

79 

 

14 

 

115 

 

297 

 

140 

    Installment & Credit Cards

 

 

11 

 

 

 


            Total Recoveries

 

351 

 

261 

 

264 

 

334 

 

539 


Net (Charge-offs) Recoveries

 

(81)

 

198 

 

(429)

 

(442)

 

(543)


Provision for Credit Losses

 

1,150 

 

-- 

 

-- 

 

-- 

 

-- 


Allowance End of Year

 

$    8,350 

 

$    7,281 

 

$    7,083 

 

$    7,512 

 

$    7,954 


 

Components:

                 

Allowance for loan losses

$    8,002 

 

$    6,911 

 

$    7,083 

 

$    7,512 

 

$    7,954 

Reserve for undisbursed lines of
  credit (1)

348 

 

370 

 

-- 

 

-- 

 

-- 


Allowance for Credit Losses

$    8,350 

 

$    7,281 

 

$    7,083 

 

$    7,512 

 

$    7,954 


 

(1)

Effective March 31, 2006 Merchants transferred the portion of the allowance for loan losses related to undisbursed lines of credit to other liabilities.

 

Merchants recorded a provision expense of $1.15 million during 2007 as a result of overall portfolio growth, an increase in internally criticized loans and the need to provide prudent and reasonable reserves for a large, non-performing residential construction project. From 2003 through 2006 the allowance for loan losses declined both in size and as a percentage of the loan portfolio. Merchants did not consider additions to the allowance necessary during those years primarily because: a large percentage of the growth in the loan portfolio had been in less risky residential categories; Merchants loss experience had been relatively low; and non-performing assets had remained at consistently low levels.

 

The following table reflects Merchants' nonperforming asset and coverage ratios as of the dates indicated:

 
 

2007

2006

2005

2004

2003


NPL to total loans

1.26%

0.39%

0.39%

0.57%

0.39%

NPA to total assets

0.83%

0.26%

0.22%

0.32%

0.23%

Allowance for loan losses to total loans

1.09%

1.00%

1.17%

1.29%

1.40%

Allowance for loan losses to NPL

   87%

 256%

 300%

 225%

 360%

           

Merchants will continue to take all appropriate measures to restore nonperforming assets to performing status or otherwise liquidate these assets in an orderly fashion so as to maximize their value to Merchants. There can be no assurances that Merchants will be able to complete the disposition of nonperforming assets without incurring further losses.

 

<PAGE>  31

Loan Portfolio Monitoring

Merchants' Board of Directors grants each loan officer the authority to originate loans on behalf of Merchants, subject to certain limitations. The Board of Directors also establishes restrictions regarding the types of loans that may be granted and the distribution of loan types within Merchants' portfolio, and sets loan authority limits for each lender. These authorized lending limits are reviewed at least annually and are based upon the lender's knowledge and experience. Loan requests that exceed a lender's authority require the signature of Merchants' credit division manager, senior loan officer, and/or Merchants' President. All extensions of credit of $2.5 million or greater to any one borrower, or related party interest, are reviewed and approved by the Loan Committee of Merchants Bank's Board of Directors.

 

The Loan Committee and the credit department regularly monitor Merchants' loan portfolio. The entire loan portfolio, as well as individual loans, is reviewed for loan performance, compliance with internal policy requirements and banking regulations, creditworthiness, and strength of documentation. Merchants monitors loan concentrations by individual borrowers, industries and loan types. As part of the annual credit policy review process, targets are set by loan type for the total portfolio. Merchants has hired external loan review firms to assist in monitoring both the commercial and residential loan portfolios. During 2007 the commercial loan review firm performed three comprehensive reviews of Merchants' loan portfolio, and reviewed approximately 75% (in dollar volume) of Merchants' commercial loan portfolio. Credit risk ratings are assigned to commercial loans at origination and are routinely reviewed by both management and the external loan review firms. Merchants plans to move its loan review function back in house during 2008. This change will give management expanded control of the timing, focus and depth of reviews.

 

All loan officers are required to service their loan portfolios and account relationships. As necessary, with the supervision of the Senior Lender and the Senior Credit Officer, loan officers or the credit department personnel take remedial actions to assure full and timely payment of loan balances.

 

AUTHORIZED COMMON STOCK

 

At the end of August 2006, during a review of Merchants' corporate records, it was discovered that Certificates of Amendment relating to the last two Amendments to Merchants' Certificate of Incorporation to increase the number of authorized common stock to 7,500,000 shares (1997 Amendment) and 10,000,000 shares (2002 Amendment), respectively, had inadvertently not been filed with the Delaware authorities. Certificates reflecting those Amendments which had been properly approved by Merchants' Board of Directors and shareholders at the relevant times were immediately filed. Merchants then reviewed with counsel the status of shares that had been issued in connection with the 2001 stock split, which, because the 1997 Amendment had not been filed, resulted in more shares being issued than were then authorized. The advice Merchants received was that failure to file created a legal irregularity or deficiency as to the excess shares which was cured by the subsequent filing of the 1997 Amendment. On this basis, Merchants has concluded that its authorized and issued common stock is correctly reflected in Merchants' records and that no additional action in this connection is required.

 

RELATED PARTY TRANSACTIONS

 

Merchants engages in banking transactions with certain of its directors and officers, and certain of their affiliates. During 2007 Merchants obtained legal services from a firm associated with one of its directors totaling $30 thousand; and project management services from a firm associated with one of its directors totaling $59 thousand. Merchants obtained insurance during 2007 through an insurance agency ("Agency") of which a director of Merchants Bank is president. In 2007, premiums paid to the Agency totaled $210 thousand. Merchants obtains these services on terms that are comparable to those that it would obtain from unaffiliated third parties.

 

At December 31, 2007, Merchants had loans outstanding to directors, executive officers, and associates of such persons totaling $3.33 million. It is the policy of Merchants to make these loans on substantially the same terms, including interest rates and collateral, as those prevailing for comparable lending transactions with other persons. As of December 31, 2007, all loans to directors, officers, and certain of their affiliates, were performing in accordance with their contractual terms.

<PAGE>  32

EFFECTS OF INFLATION

 

The financial nature of Merchants' consolidated balance sheet and statement of income is more clearly affected by changes in interest rates than by inflation, but inflation does affect Merchants because as prices increase the money supply tends to increase, the size of loans requested tends to increase, total company assets increase, and interest rates are affected by inflationary expectations. In addition, operating expenses tend to increase without a corresponding increase in productivity. There is no precise method, however, to measure the effects of inflation on Merchants' financial statements. Accordingly, any examination or analysis of the financial statements should take into consideration the possible effects of inflation.

 

RECENT ACCOUNTING PRONOUNCEMENTS

 

In December 2007, the Financial Accounting Standards Board ("FASB") issued revised Statement of Financial Accounting Standards ("SFAS") No. 141, "Business Combinations," or SFAS No. 141(R). SFAS No. 141(R) retains the fundamental requirements of SFAS No. 141 that the acquisition method of accounting (formerly the purchase method) be used for all business combinations; that an acquirer be identified for each business combination; and that intangible assets be identified and recognized separately from goodwill. SFAS No. 141(R) requires the acquiring entity in a business combination to recognize the assets acquired, the liabilities assumed and any noncontrolling interest in the acquiree at the acquisition date, measured at their fair values as of that date, with limited exceptions. Additionally, SFAS No. 141(R) changes the requirements for recognizing assets acquired and liabilities assumed arising from contingencies and recognizing and measuring contingent consideration. SFAS No. 141(R) also enhances the disclosure requirements for business combinations. SFAS No. 141(R) applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008 and may not be applied before that date.

 

In December 2007, the FASB issued SFAS No. 160, "Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB no. 51," or SFAS No. 160. SFAS No. 160 amends Accounting Research Bulletin No. 51, "Consolidated Financial Statements" to establish accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. Among other things, SFAS No. 160 clarifies that a noncontrolling interest in a subsidiary is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial statements and requires consolidated net income to be reported at amounts that include the amounts attributable to both the parent and the noncontrolling interest. SFAS No. 160 also amends SFAS No. 128, "Earnings per Share," so that earnings per share calculations in consolidated financial statements will continue to be based on amounts attributable to the parent. SFAS No. 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008 and is applied prospectively as of the beginning of the fiscal year in which it is initially applied, except for the presentation and disclosure requirements which are to be applied retrospectively for all periods presented. SFAS No. 160 is not expected to have a material impact on our financial condition or results of operations.

 

In November 2007, the Securities and Exchange Commission ("SEC"), issued Staff Accounting Bulletin ("SAB") No. 109, "Written Loan Commitments Recorded at Fair Value Through Earnings." SAB No. 109 provides views on the accounting for written loan commitments recorded at fair value under GAAP. SAB No. 109 supersedes SAB No. 105, "Application of Accounting Principles to Loan Commitments." Specifically, SAB No. 109 states that the expected net future cash flows related to the associated servicing of a loan should be included in the measurement of all written loan commitments that are accounted for at fair value through earnings. The provisions of SAB No. 109 are applicable on a prospective basis to written loan commitments recorded at fair value under GAAP that are issued or modified in fiscal quarters beginning after December 15, 2007. SAB No. 109 is not expected to have a material impact on our financial condition or results of operations.

 

In June 2007, the FASB ratified a consensus reached by the Emerging Issues Task Force ("EITF") on Issue No. 06-11, "Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards," which clarifies the accounting for income tax benefits related to the payment of dividends on equity-classified employee share-based payment awards that are charged to retained earnings under SFAS No. 123(R). The EITF concluded that a realized income tax benefit from dividends or dividend equivalents that are charged to retained earnings and are paid to

<PAGE>  33

employees for equity classified nonvested equity shares, nonvested equity share units and outstanding equity share options should be recognized as an increase to additional paid-in capital. EITF Issue No. 06-11 should be applied prospectively to the income tax benefits that result from dividends on equity-classified employee share-based payment awards that are declared in fiscal years beginning after December 15, 2007, and interim periods within those fiscal years. Retrospective application to previously issued financial statements is prohibited. EITF Issue No. 06-11 is not expected to have a material impact on our financial condition or results of operations.

 

In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities, Including an amendment of FASB Statement No. 115," which permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. At the effective date, an entity may elect the fair value option for eligible items that exist at that date and report the effect of the first remeasurement to fair value as a cumulative-effect adjustment to the opening balance of retained earnings. Subsequent to the effective date, unrealized gains and losses on items for which the fair value option has been elected are to be reported in earnings. If the fair value option is elected for any available-for-sale or held-to-maturity securities at the effective date, cumulative unrealized gains and losses at that date are included in the cumulative-effect adjustment and those securities are to be reported as trading securities under SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," but the accounting for a transfer to the trading category under SFAS No. 115 does not apply. Electing the fair value option for an existing held-to-maturity security will not call into question the intent of an entity to hold other debt securities to maturity in the future. SFAS No. 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. SFAS No. 159 does not affect any existing accounting literature that requires certain assets and liabilities to be carried at fair value and does not eliminate disclosure requirements included in other accounting standards. SFAS No. 159 is effective as of the beginning of an entity's first fiscal year that begins after November 15, 2007. Early adoption was permitted; however, we did not elect early adoption and therefore adopted the standard as of January 1, 2008. Upon adoption, we did not elect the fair value option for eligible items that existed at January 1, 2008.

 

In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements," which defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. The expanded disclosures include a requirement to disclose fair value measurements according to a hierarchy, segregating measurements using (1) quoted prices in active markets for identical assets and liabilities, (2) significant other observable inputs and (3) significant unobservable inputs. SFAS No. 157 applies only to fair value measurements already required or permitted by other accounting standards and does not impose requirements for additional fair value measures. SFAS No. 157 was issued to increase consistency and comparability in reporting fair values. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The provisions are to be applied prospectively as of the beginning of the fiscal year in which the statement is initially applied, with certain exceptions. A transition adjustment, measured as the difference between the carrying amounts and the fair values of certain specific financial instruments at the date SFAS No. 157 is initially applied, is to be recognized as a cumulative-effect adjustment to the opening balance of retained earnings for the fiscal year in which SFAS No. 157 is initially applied. SFAS No. 157 will affect certain of our fair value disclosures, but is not expected to have a material impact on our financial condition or results of operations.

 

In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing of Financial Assets." This Statement was issued to simplify the accounting for servicing rights and to reduce the volatility that results from using different measurement attributes. SFAS 156 requires companies to recognize a servicing asset or servicing liability each time they undertake an obligation to service a financial asset by entering into a servicing contract. The Statement permits a company to choose either the amortized cost method or fair value measurement method for each class of separately recognized servicing assets. This statement is effective as of the beginning of a company's first fiscal year after September 15, 2006. The adoption of SFAS 156 is not expected to have a material effect on our consolidated financial position, results of operations or cash flows.

<PAGE>  34

Liquidity and Capital Resource Management

 

General

Liquidity, as it pertains to banking, can be defined as the ability to meet cash commitments at all times in the most economical way to satisfy loan and deposit withdrawal demand, and to meet other business opportunities that require cash. Sources of liquidity for banks include short-term liquid assets, cash generated from loan repayments and amortization, borrowing, deposit generation and earnings. Merchants has a number of sources of liquid funds, including $44 million in available Federal Funds lines of credit with correspondent banks at year-end 2007; an overnight line of credit with the FHLB of $5 million; an estimated additional borrowing capacity with the FHLB of $129 million; and the ability to borrow through the use of repurchase agreements, collateralized by Merchants' investments, with certain approved counterparties. Merchants' investment portfolio, which totaled $365.59 million at December 31, 2007, is actively managed by the Merchants' Asset Liability Committee ("ALCO") and is a strong source of cash flow for Merchants. At December 31, 2007, $174.32 million of the portfolio was pledged for repurchase agreements and other specific relationships, the balance of the portfolio is fairly liquid, with a weighted average life of approximately 2.9 years, and is available to be used as a source of funds, if needed.

 

Contractual Obligations

Merchants has certain long-term contractual obligations; including long-term debt agreements, operating leases for branch operations, and time deposits. The maturity schedules for these obligations are as follows:

 

(In thousands)

Less than
One Year

One Year
To Three
Years

Three
Years To
Five Years

Over Five
Years

Total


Debt maturities

 

$  28,005

 

$31,652

 

$       95

 

$  2,365

 

$  62,117

Securities sold under agreement
  to repurchase, long-term

 

20,000

 

--

 

21,500

 

--

 

41,500

Junior subordinated debentures

 

--

 

--

 

--

 

20,619

 

20,619

Operating lease payments

 

771

 

1,511

 

1,269

 

3,098

 

6,649

Time deposits

 

308,461

 

18,422

 

5,889

 

--

 

332,772


   

$357,237

 

$51,585

 

$28,753

 

$26,082

 

$463,657


 

Commitments and Off-Balance Sheet Risk

Merchants is a party to financial instruments with offbalance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments primarily include commitments to extend credit and financial guarantees. Such instruments involve, to varying degrees, elements of credit and interest rate risk that are not recognized in the accompanying Consolidated Balance Sheets.

 

Exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and financial guarantees written is represented by the contractual amount of those instruments. Merchants uses the same credit policies in making commitments as it does for on balance sheet instruments. The contractual amounts of these financial instruments at December 31, 2007, are as follows:

 
 

(In thousands)

 

Contractual
Amount

 
 


 
 

Financial Instruments Whose Contract Amounts

     
 

  Represent Credit Risk:

     
 

    Commitments to Originate Loans

 

$  10,603

 
 

    Unused Lines of Credit

 

131,085

 
 

    Standby Letters of Credit

 

5,221

 
 

    Loans Sold with Recourse

 

403

 
 

Equity Commitments to Affordable Housing

     
 

  Limited Partnerships

 

1,479

 
 


 

<PAGE>  35

Commitments to originate loans are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments to originate loans generally have expiration dates within 60 days of the commitment. Unused lines of credit have expiration dates ranging from one to two years from the date of the commitment. Since a portion of the commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent a future cash requirement. Merchants evaluates each customer's creditworthiness on a case-by-case basis. Upon extension of credit Merchants obtains an appropriate amount of real and/or personal property as collateral based on management's credit evaluation of the counterparty.

 

FASB Interpretation No. 45 ("FIN No. 45"), "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others; an Interpretation of FASB Statements No. 5, 57, and 107, and rescission of FASB Interpretation No. 34," requires certain disclosures and liability-recognition for the fair value at issuance of guarantees that fall within its scope. Under FIN No. 45, Merchants does not issue any guarantees that would require liability-recognition or disclosure, other than its standby letters of credit. Merchants has issued conditional commitments in the form of standby letters of credit to guarantee payment on behalf of a customer and guarantee the performance of a customer to a third party. Standby letters of credit generally arise in connection with lending relationships. The credit risk involved in issuing these instruments is essentially the same as that involved in extending loans to customers. Contingent obligations under standby letters of credit totaled approximately $5.22 million and $6.15 million at December 31, 2007 and 2006, respectively, and represent the maximum potential future payments Merchants could be required to make. Typically, these instruments have terms of 12 months or less and expire unused; therefore, the total amounts do not necessarily represent future cash requirements. Each customer is evaluated individually for creditworthiness under the same underwriting standards used for commitments to extend credit and on-balance sheet instruments. Merchants' policies governing loan collateral apply to standby letters of credit at the time of credit extension. Loan-to-value ratios are generally consistent with loan-to-value requirements for other commercial loans secured by similar types of collateral. The fair value of Merchants' standby letters of credit at December 31, 2007 and 2006 was insignificant.

 

Equity commitments to affordable housing partnerships represent funding commitments by Merchants to certain limited partnerships. These partnerships were created for the purpose of acquiring, constructing and/or redeveloping affordable housing projects. The funding of these commitments is generally contingent upon substantial completion of the project and none extend beyond the fifth anniversary of substantial completion.

 

Capital Resources

In general, capital growth is essential to support deposit and asset growth and to ensure the strength and safety of Merchants. Net income increased Merchants' capital by $10.86 million in 2007, $10.87 million in 2006 and $11.90 million in 2005. Payment of dividends decreased Merchants' capital by $6.90 million, $7.04 million and $6.83 million during 2007, 2006 and 2005, respectively. In December 2004 Merchants, through a newly formed subsidiary business trust, privately placed $20 million in capital securities as part of pooled trust preferred program. These capital securities have certain features that make them an attractive funding vehicle. The securities qualify as regulatory capital under regulatory adequacy guidelines, and are included in capital in the table below. Merchants remained well capitalized under applicable regulatory guidelines after the payment of the special dividend both with and without the trust preferred securities.

 

Stock repurchases decreased Merchants' capital by $3.48 million during 2007 and by $3.99 million during 2006. In addition, changes in the market value of Merchants' available for sale investment portfolio, net of tax, increased capital by $3.61 million in 2007. Merchants' unrecognized net actuarial loss in its pension plan reduced capital by $2.05 million on a pre-tax basis at December 31, 2007, which resulted in a cumulative after-tax charge to equity of $1.33 million. The tax-effected adjustment was a $426 thousand increase to Other Comprehensive Income during 2007.

<PAGE>  36

As of December 31, 2007, the most recent notification from the FDIC categorized Merchants Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed Merchants Bank's category. To be considered well capitalized under the regulatory framework for prompt corrective action, Merchants Bank must maintain minimum Tier 1 Leverage, Tier 1 Risk-Based and Total Risk-Based Capital ratios. The ratios for Merchants are set forth below:

 

(In thousands)

Amount (1)

Actual
Percentage

 


 
 

Tier 1 Leverage Capital

 

$  95,258

 

8.14%

 
 

Tier 1 Risk-Based Capital

 

95,258

 

12.75%

 
 

Total Risk-Based Capital

 

103,608

 

13.86%

 
 


 
 

(1)

Capital amounts include $20 million in trust preferred securities issued in December 2004. These hybrid securities qualify as regulatory capital up to certain regulatory limits.

 

In January 2007 Merchants' Board of Directors approved a stock repurchase program, pursuant to which Merchants may repurchase 200,000 shares of its stock from time to time through January 2008. At its meeting in January 2008, the Board extended the program through January 2009. Through December 31, 2007, Merchants purchased 59,118 shares of its common stock on the open market under the program at an average per share price of $22.89.

 

ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

RISK MANAGEMENT

 

General

Management and the Board of Directors of Merchants are committed to sound risk management practices throughout the organization. Merchants has developed and implemented a centralized risk management monitoring program. Risks associated with Merchants' business activities and products are identified and measured as to probability of occurrence and impact on Merchants (low, moderate, or high), and the control or other activities in place to manage those risks are identified and assessed. Periodically, department-level and senior managers re-evaluate and report on the risk management processes for which they are responsible. This documented program provides management with a comprehensive framework for monitoring Merchants' risk profile from a macro perspective; it also serves as a tool for assessing internal controls over financial reporting as required under the FDICIA and the Sarbanes-Oxley Act of 2002.

 

Market Risk

Market risk is the risk of loss in a financial instrument arising from adverse changes in market rates or prices such as interest rates, foreign currency exchange rates, commodity prices, and equity prices. Merchants' primary market risk exposure is interest rate risk. An important component of Merchants' asset and liability management process is the ongoing monitoring and management of this risk, which is governed by established policies that are reviewed and approved annually by Merchants Bank's Board of Directors. The Investment policy details the types of securities that may be purchased, and establishes portfolio limits and maturity limits for the various sectors. The Investment policy also establishes specific investment quality limits. Merchants Bank's Board of Directors has established a board level Asset and Liability Committee, which delegates responsibility for carrying out the asset/liability management policies to the management level Asset and Liability Committee ("ALCO"). The ALCO, chaired by the Chief Financial Officer and composed of members of senior management, develops guidelines and strategies impacting Merchants' asset and liability management related activities based upon estimated market risk sensitivity, policy limits and overall market interest rate levels and trends. The ALCO manages the investment portfolio. As the portfolio has grown, the ALCO has used portfolio diversification as a way to mitigate the risk of being too heavily invested in any single asset class. Merchants continued to work to maximize net interest income while mitigating risk during 2007 through further repositioning of the investment portfolio, selective sales of specific securities, as well as carefully monitoring the overall duration and average life of the portfolio, and monitoring individual securities, among other strategies. Merchants had discontinued investing in the portfolio during the second quarter of 2006 through the second quarter of 2007 because of the sustained flat to inverted yield curve environment. As the curve steepened

<PAGE>  37

during the second half of 2007 Merchants began reinvesting in the portfolio, and purchased $82.58 million in securities during the fourth quarter. The purchases were funded by a mix of borrowed funds and redeployment of funds that had been sold overnight, as well as amortization from the investment and loan portfolios. Merchants has an outside investment advisory firm which helps it identify opportunities for increased yield, without significantly increasing risk, in the investment portfolio. The firm specializes in stable value and fixed income portfolios, and has a staff of investment professionals who research and track each bond. The ALCO and the investment advisor have frequent conference calls to discuss portfolio activity and to set future strategy. Additionally, any specific bonds or sectors that require additional attention are discussed on these calls.

 

Merchants holds one bond totaling $2.17 million that is classified as "sub-prime". The bond is secured by first liens on residential property, and was originated in 2002. Delinquencies of 60 days and longer on the bond have been in the 15-20% range since the bond was purchased. The coupon on the bond is substantially lower than the average coupon on the underlying mortgages, this excess interest is used to create a large pool of over-collateralization, and the bond is currently over-collateralized by 17%. The bond is AAA rated, and is insured by Ambac. Ambac has recently come under pressure and announced a substantial loss for the fourth quarter of this year, slashed its dividend and was downgraded by Fitch Investor Services. Ambac's AAA rating was recently affirmed by S&P, although this rating agency maintains Ambac on negative watch. The bond may lose its AAA rating if Ambac is downgraded further. Merchants' investment advisor stress-tested this bond extensively and determined that even if the insurer was not able to support the bond the current market value was reasonable.

 

Interest Rate Risk

Interest rate risk is the exposure to a movement in interest rates, which, as described above, affects Merchants' net interest income. Asset and liability management is governed by policies reviewed and approved annually by Merchants Bank's Board of Directors. The ALCO meets frequently to review and develop asset/liability management strategies and tactics.

 

The ALCO is responsible for evaluating and managing the interest rate risk which arises naturally from imbalances in repricing, maturity and cash flow characteristics of Merchants' assets and liabilities. Techniques used by the ALCO take into consideration the cash flow and repricing attributes of balance sheet and off-balance sheet items and their relation to possible changes in interest rates. The ALCO manages interest rate exposure primarily by using on-balance sheet strategies, generally accomplished through the management of the duration, rate sensitivity and average lives of Merchants' various investments, and by extending or shortening maturities of borrowed funds, as well as carefully managing and monitoring the pricing of loans and deposits. The ALCO also considers the use of off-balance sheet strategies, such as interest rate caps and floors and interest rate swaps, to help minimize the Company's exposure to changes in interest rates. Merchants entered into a $30 million interest rate cap arrangement during January of 2007 to help mitigate its exposure to rising short-term interest rates. The cap is recorded on Merchants' balance sheet at fair value with subsequent changes in fair value recorded through earnings each quarter. Additionally, as Merchants began to reinvest in its investment portfolio during the second half of 2007, management also took advantage of the steepened yield curve to add some leverage to the balance sheet. Merchants borrowed $43.50 million during the fourth quarter of the year in a mix of bullet and amortizing FHLB advances, as well as structured repurchase agreements. The structured repurchase agreements have a five year final maturity, are callable in two years, and have embedded double caps that will provide additional protection if rates start to move up. The ALCO uses an outside consultant to perform rate shocks of its balance sheet and a variety of other analyses.

 

The ALCO is responsible for ensuring that Merchants Bank's Board of Directors receives accurate information regarding Merchants' interest rate risk position at least quarterly. The investment advisory firm and ALCO consultant meet collectively with the board and management level Asset and Liability Committees on a quarterly basis. During these meetings the ALCO consultant reviews Merchants' current position and discusses future strategies, and the investment advisor reports on the overall performance of the portfolio and performs modeling of the cash flow, effective duration, and yield characteristics of the portfolio under various interest rate scenarios; and also reviews and provides detail on individual holdings in the portfolio.

<PAGE>  38

As of December 31, 2007 Merchants' one-year static gap position was a $247.17 million liability sensitive position, and had changed very little from the $255.16 million liability sensitive position at December 31, 2006. Merchants has established a target range for the change in net interest income, given a parallel 200 basis point change in interest rates, of zero to 7.5%. The net interest income simulation as of December 31, 2007 showed that the change in net interest income for the next 12 months from Merchants' expected or "most likely" forecast was as follows:

 
 

Rate Change

Percent Change in
Net Interest Income

 


 
 

Up 200 basis points

 

(2.10%)

 
 

Down 200 basis points

 

1.30%

 
 


 
 

This analysis assumes a static balance sheet and parallel yield curve shifts from December 31, 2007 interest rate levels. As rates increase with a parallel yield curve shift net interest income decreases over the first year as increases in funding costs outstrip higher asset yields. The exposure to rising rates has been somewhat mitigated by the use of structured funding products. The margin starts to trend up again in year two as increases in funding costs subside while longer term asset cash flow continues to benefit from a higher rate environment. As rates fall with a parallel yield curve shift net interest income increases over the first year due to the short term funding base repricing more quickly than assets. Margins start to trend down in year two as the decline in liability costs slow while prepayment speeds on assets increase and are reinvested at lower yields. If the yield curve steepens as rates fall much of this exposure could be reduced or eliminated. The degree to which this exposure materializes will depend, in part, on Merchants' ability to manage deposit and loan rates as interest rates rise or fall.

 

The consultant also ran additional simulations, and modeled a down 200 basis points scenario with a steepening yield curve, and a 400 basis point upward movement in rates. Results from the steepening yield curve scenario showed that Merchants' margin would increase considerably when compared to the base scenario in a steepening environment. The results from the model with the 400 basis point upward parallel shift showed that margin decreased considerably through the first three years, then rebounded and moved up during years four and five. These types of dynamic analyses give the ALCO a more thorough understanding of how Merchants' balance sheet will perform in a variety of rate environments.

 

The preceding sensitivity analysis does not represent Merchants' forecast and should not be relied upon as being indicative of expected operating results. These estimates are based upon numerous assumptions including without limitation: the nature and timing of interest rate levels including yield curve shape, prepayments on loans and securities, deposit run-off rates, pricing decisions on loans and deposits and reinvestment/replacement of asset and liability cash flows, among others. While assumptions are developed based upon current economic and local market conditions, Merchants cannot make any assurances as to the predictive nature of these assumptions including how customer preferences or competitor influences might change.

 

The most significant factors affecting market risk exposure of net interest income during the year ended December 31, 2007 were the shape and level of the U.S. Government securities and interest rate swap yield curve, and changes in the size and composition of the loan, investment and deposit portfolios. During 2007, the two year treasury decreased by 175 basis points and the ten year treasury decreased by 64 basis points, the spread between the two-year and the ten-year treasuries ended the year at 99 basis points, compared to a 12 basis point inversion at December 31, 2006.

 

As market conditions vary from those assumed in the sensitivity analysis, actual results will likely differ due to: the varying impact of changes in the balances and mix of loans and deposits differing from those assumed, the impact of possible off-balance sheet hedging strategies, and other internal/external variables. Furthermore, the sensitivity analysis does not reflect all actions that ALCO might take in responding to or anticipating changes in interest rates.

<PAGE>  39

The model used to perform the balance sheet simulation assumes a parallel shift of the yield curve over twelve months and reprices every interest-bearing asset and liability on Merchants' balance sheet. The model uses contractual repricing dates for variable products, contractual maturities for fixed rate products, and product-specific assumptions for deposits such as Free Checking for Life accounts and Money Market accounts which are subject to repricing based on current market conditions. Investment securities with call provisions are examined on an individual basis in each rate environment to estimate the likelihood of a call. The model also assumes that the rate at which certain mortgage related assets prepay will vary as rates rise and fall, based on prepayment estimates derived from the Office of Thrift Supervision Net Portfolio Value Model.

 

Merchants' interest rate sensitivity gap ("gap") is pictured below as of December 31, 2007. Interest rate gap analysis provides a static view of the maturity and repricing characteristics of Merchants' on and off-balance sheet positions. Gap is defined as the difference between assets and liabilities repricing or maturing within specified periods. An asset-sensitive position (positive gap) indicates that there are more rate-sensitive assets than rate-sensitive liabilities repricing or maturing within a specified time period, which would imply a favorable impact on net interest income during periods of rising interest rates. Conversely, a liability-sensitive position (negative gap) generally implies a favorable impact on net interest income during periods of falling interest rates. There are certain limitations inherent in a static gap analysis. These limitations include the fact that it is a static measurement and that it does not reflect the degrees to which interest earning assets and interest bearing deposits may respond non-proportionally to changes in market interest rates. Although the ALCO reviews all assumptions used in the model in detail, assets and liabilities do not always have clear repricing dates, and may reprice earlier or later than assumed in the model.

 
 

Repricing Date


(In thousands)

One Day
To Six
Months

Over Six
Months To
One Year

One Year
To Five
Years

Over Five
Years

Total


                   

Interest-earning assets

                 

    Loans

$ 201,198 

 

$   70,647 

 

$357,545

 

$102,118

 

$   731,508

    U.S. Treasury & Agency Securities

4,904 

 

4,903 

 

6,193

 

--

 

16,000

    Mortgage Backed Securities and
      Collateralized Mortgage Obligations

38,988 

 

34,658 

 

174,816

 

43,815

 

292,277

    Other securities

13,553 

 

6,083 

 

33,438

 

4,240

 

57,314

    Interest bearing cash equivalents

25,214 

 

-- 

 

--

 

--

 

25,214


Total interest-earning assets

$ 283,857 

 

$ 116,291 

 

$571,992

 

$150,173

 

$1,122,313


Interest-bearing liabilities:

                 

    Interest-bearing deposits

$ 367,674 

 

$ 132,633 

 

$243,786

 

--

 

$   744,093

    Short-term borrowings

98,917 

 

-- 

 

--

 

--

 

98,917

    Long-term debt

41,472 

 

6,619 

 

75,145

 

1,000

 

124,236


Total interest-bearing liabilities

$ 508,063 

 

$ 139,252 

 

$318,931

 

$    1,000

 

$   967,246


    Cumulative Gap

$(224,206)

 

$(247,167)

 

$    5,894

 

$155,067

   

    Cumulative Gap as a % of

                 

      average earning assets

(20.85%)

 

(22.98%)

 

0.55%

 

14.42%

   


 

Based on historical experience and Merchants' internal repricing policies, it is Merchants' practice to present repricing of statement savings, savings deposits, Free Checking for Life and NOW account balances in the "One Year to Five Years" category. Merchants' experience has shown that the rates on these deposits tend to be less rate-sensitive than other types of deposits.

<PAGE>  40

Credit Risk

The Board of Directors reviews and approves Merchants' loan policy on an annual basis. Among other things, the loan policy establishes restrictions regarding the types of loans that may be granted, and the distribution of loan types within Merchants' portfolio. Merchants Bank's Board of Directors grants each loan officer the authority to originate loans on behalf of Merchants, subject to certain limitations. These authorized lending limits are reviewed at least annually and are based upon the lender's knowledge and experience. Loan requests that exceed a lender's authority require the signature of Merchants' credit division manager, senior loan officer, and/or president. All extensions of credit of $2.5 million or greater to any one borrower or related party interest are reviewed and approved by the Loan Committee of Merchants Bank's Board of Directors. Merchants' loan portfolio is continuously monitored for performance, creditworthiness and strength of documentation through the use of a variety of management reports and, through 2007, the assistance of an external loan review firm. The loan review function will be moved in-house during 2008. This will give management better control of timing, focus, scope and depth of reviews going forward. Credit ratings are assigned to commercial loans and are routinely reviewed. Loan officers, under the supervision of the Senior Lender and Senior Credit Officer, take remedial actions to assure full and timely payment of loan balances when necessary. Merchants' policy is to discontinue the accrual of interest on loans when scheduled payments become contractually past due 90 or more days and the ultimate collectibility of principal or interest become doubtful. In certain instances the accrual of interest is discontinued prior to 90 days past due if management determines that the borrower will not be able to continue making timely payments.

<PAGE>  41

ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

Merchants Bancshares, Inc.

Consolidated Balance Sheets

 

(In thousands except share and share data)

December 31,
2007

December 31,
2006


ASSETS

       

    Cash and cash equivalents

 

$     29,720 

 

$     36,706 

    Federal funds sold and other short-term investments

 

20,100 

 

42,000 


            Total cash and cash equivalents

 

49,820 

 

78,706 


    Investments:

       

        Securities available for sale, at fair value

 

361,512 

 

333,958 

        Securities held to maturity (fair value of $4,283 and $5,804)

 

4,078 

 

5,615 


            Total investments

 

365,590 

 

339,573 


    Loans

 

731,508 

 

689,283 

    Less: Allowance for loan losses

 

8,002 

 

6,911 


            Net loans

 

723,506 

 

682,372 


    Federal Home Loan Bank stock

 

5,114 

 

5,486 

    Bank premises and equipment, net

 

11,484 

 

12,538 

    Investment in real estate limited partnerships

 

7,215 

 

8,925 

    Other assets

 

8,014 

 

9,358 


            Total assets

 

$1,170,743 

 

$1,136,958 


LIABILITIES

       

    Deposits:

       

        Demand deposits

 

$   123,344 

 

$   122,036 

        Savings, NOW and money market accounts

 

411,321 

 

442,442 

        Time deposits $100 thousand and greater

 

85,738 

 

76,822 

        Other time deposits

 

247,034 

 

236,052 


            Total deposits

 

867,437 

 

877,352 


    Securities sold under agreements to repurchase and other short-term debt

 

98,917 

 

90,547 

    Securities sold under agreements to repurchase, long-term

 

41,500 

 

20,000 

    Other long-term debt

 

62,117 

 

53,863 

    Junior subordinated debentures issued to unconsolidated subsidiary trust

 

20,619 

 

20,619 

    Other liabilities

 

4,846 

 

4,880 


            Total liabilities

 

1,095,436 

 

1,067,261 


Commitments and contingencies (Note 14)

       

SHAREHOLDERS' EQUITY

       

    Preferred stock Class A non-voting
        Shares authorized - 200,000, none outstanding

 

-- 

 

-- 

    Preferred stock Class B voting
        Shares authorized - 1,500,000, none outstanding

 

-- 

 

-- 

    Common stock, $.01 par value

 

67 

 

67 

        Shares authorized

 

10,000,000

       

        Issued

As of December 31, 2007

 

6,651,760

       
 

As of December 31, 2006

 

6,651,760

       

        Outstanding

As of December 31, 2007

 

5,770,948

       
 

As of December 31, 2006

 

5,873,290

       

    Capital in excess of par value

 

37,264 

 

37,413 

    Retained earnings

 

52,570 

 

48,609 

    Treasury stock, at cost

 

(19,214)

 

(16,766)

 

As of December 31, 2007

 

880,812

       
 

As of December 31, 2006

 

778,470

       

    Deferred compensation arrangements

 

6,042 

 

5,833 

    Accumulated other comprehensive loss

 

(1,422)

 

(5,459)


            Total shareholders' equity

 

75,307 

 

69,697 


            Total liabilities and shareholders' equity

 

$1,170,743 

 

$1,136,958 


 

See accompanying notes to consolidated financial statements.

<PAGE>  42

Merchants Bancshares, Inc.

Consolidated Statements of Income

 
   

Years Ended December 31,

(In thousands except share and per share data)

 

2007

 

2006

 

2005


INTEREST AND DIVIDEND INCOME:

           

    Interest and fees on loans

 

$ 47,269 

 

$ 43,446  

 

$ 36,627 

    Investment income:

           

        Interest on debt securities

 

15,096 

 

17,709 

 

16,762 

        Dividends

 

352 

 

467 

 

381 

        Interest on fed funds sold, short-term investments and
          interest bearing deposits

 

1,882 

 

375 

 

39 


Total interest and dividend income

 

64,599 

 

61,997 

 

53,809 


INTEREST EXPENSE:

           

    Savings, NOW and money market accounts

 

4,779 

 

5,191 

 

3,940 

    Time deposits $100 thousand and greater

 

2,816 

 

2,025 

 

1,136 

    Other time deposits

 

10,365 

 

7,453 

 

3,925 

    Securities sold under agreement to repurchase and other
      short-term debt

 

3,503 

 

4,060 

 

1,517 

    Long-term debt

 

4,923 

 

4,560 

 

3,356 


Total interest expense

 

26,386 

 

23,289 

 

13,874 


Net interest income

 

38,213 

 

38,708 

 

39,935 

    Provision for loan losses

 

1,150 

 

-- 

 

-- 


Net interest income after provision for loan losses

 

37,063 

 

38,708 

 

39,935 


NONINTEREST INCOME:

           

    Trust company income

 

1,957 

 

1,763 

 

1,652 

    Service charges on deposits

 

5,474 

 

5,276 

 

4,985 

    Net losses on investment securities

 

(97)

 

(464)

 

(32)

    Equity in losses of real estate limited partnerships

 

(1,484)

 

(1,535)

 

(1,712)

    Other

 

3,494 

 

3,148 

 

2,907 


Total noninterest income

 

9,344 

 

8,188 

 

7,800 


NONINTEREST EXPENSES:

           

    Salaries and wages

 

12,211 

 

12,226 

 

12,256 

    Employee benefits

 

3,421 

 

3,923 

 

3,622 

    Occupancy expense

 

3,252 

 

3,180 

 

3,104 

    Equipment expense

 

2,761 

 

2,841 

 

3,013 

    Legal and professional fees

 

2,411 

 

2,432 

 

2,112 

    Marketing

 

1,199 

 

1,455 

 

1,372 

    State franchise taxes

 

992 

 

941 

 

948 

    Other real estate owned

 

383 

 

52 

 

15 

    Other

 

5,658 

 

5,674 

 

5,640 


Total noninterest expenses

 

32,288 

 

32,724 

 

32,082 


Income before provision for income taxes

 

14,119 

 

14,172 

 

15,653 

Provision for income taxes

 

3,261 

 

3,301 

 

3,751 


NET INCOME

 

$ 10,858 

 

$ 10,871 

 

$ 11,902 


             

Basic earnings per common share

 

$     1.77 

 

$     1.73 

 

$     1.88 

Diluted earnings per common share

 

$     1.76 

 

$     1.73 

 

$     1.87 

             

Weighted average common shares outstanding

 

6,148,494 

 

6,275,709 

 

6,318,524 

Weighted average diluted shares outstanding

 

6,164,441 

 

6,299,763 

 

6,360,675 

             

See accompanying notes to the consolidated financial statements.

<PAGE>  43

Merchants Bancshares, Inc.

Consolidated Statements of Comprehensive Income

 
 

Years Ended December 31,

(In thousands)

2007

 

2006

 

2005


Net income

$10,858

 

$10,871

 

$11,902 

Other comprehensive income (loss), net of tax:

         

    Change in net unrealized gain (loss) on securities available for sale, net
      of taxes of $1,911, $342, and $(2,553)

3,548

 

636

 

(4,741)

        Reclassification adjustments for securities losses included in
          net income, net of taxes of $34, $162, and $11

63

 

302

 

21 

        Impact of transfer of securities from available for sale to held to maturity
          net of taxes of $0, $1, and $(5)

--

 

1

 

(10)

        Amortization of previously recorded pension amounts,
          net of taxes of $229, $0 and $0

426

 

--

 

-- 

        Minimum pension liability adjustment, net of taxes of $0, $132, and $219

--

 

246

 

407 


Other comprehensive income (loss)

4,037

 

1,185

 

(4,323)


Comprehensive income

$14,895

 

$12,056

 

$  7,579 


 

See accompanying notes to the consolidated financial statements.

<PAGE>  44

Merchants Bancshares, Inc.

Consolidated Statements of Changes in Shareholders' Equity

For the Years Ended December 31, 2007, 2006 and 2005

(In thousands except per share data)

Common
Stock

Capital in
Excess of
Par Value

Retained
Earnings

Treasury
Stock

Deferred
Compensation
Arrangements

Accumulated
Other
Comprehensive
Loss

Total


Balance at December 31, 2004

$67

 

$34,490 

 

$ 38,893 

$(11,065)

$5,120 

 

$(2,321)

 

$ 65,184 


    Net income

--

 

-- 

 

11,902 

-- 

-- 

 

-- 

 

11,902 

    Dividends paid ($1.08 per share)

--

 

-- 

 

(6,830)

-- 

-- 

 

-- 

 

(6,830)

    Purchase of treasury stock

--

 

-- 

 

-- 

(4,474)

-- 

 

-- 

 

(4,474)

    Sale of treasury stock

--

 

2,159 

 

-- 

1,408 

-- 

 

-- 

 

3,567 

    Director's deferred compensation, net

--

 

-- 

 

-- 

271 

(37)

 

-- 

 

234 

    Shares issued under stock plans, net of
      excess tax benefit

--

 

368 

 

-- 

(23)

-- 

 

-- 

 

345 

    Dividend reinvestment plan

--

 

311 

 

-- 

150 

331 

 

-- 

 

792 

    Other comprehensive loss

--

 

-- 

 

-- 

-- 

-- 

 

(4,323)

 

(4,323)


Balance at December 31, 2005

$67

 

$37,328 

 

$ 43,965 

$(13,733)

$5,414 

 

$(6,644)

 

$ 66,397 


    Cumulative adjustment to beginning retained
      earnings under SAB No. 108 (Note 18)

--

 

-- 

 

810 

-- 

-- 

 

-- 

 

810 


Adjusted balance at January 1, 2006

$67

 

$37,328 

 

$ 44,775 

$(13,733)

$5,414 

 

$(6,644)

 

$ 67,207 

    Net income

--

 

-- 

 

10,871 

-- 

-- 

 

-- 

 

10,871 

    Reclassification of unearned compensation
      related to risk premium shares upon
      adoption of SFAS 123(R)

--

 

(82)

 

-- 

-- 

82 

 

-- 

 

-- 

    Dividends paid ($1.12 per share)

--

 

-- 

 

(7,037)

-- 

-- 

 

-- 

 

(7,037)

    Purchase of treasury stock

--

 

-- 

 

-- 

(3,993)

-- 

 

-- 

 

(3,993)

    Sale of treasury stock

--

 

 

-- 

-- 

 

-- 

 

11 

    Director's deferred compensation, net

--

 

(12)

 

-- 

282 

(12)

 

-- 

 

258 

    Shares issued under stock plans, net of
      excess tax benefit

--

 

(9)

 

-- 

360 

-- 

 

-- 

 

351 

    Stock option expense

--

 

10 

 

-- 

-- 

-- 

 

-- 

 

10 

    Dividend reinvestment plan

--

 

176 

 

-- 

309 

349 

 

-- 

 

834 

    Other comprehensive income

--

 

-- 

 

-- 

-- 

-- 

 

1,185 

 

1,185 


Balance at December 31, 2006

$67

 

$37,413 

 

$ 48,609 

$(16,766)

$5,833 

 

$(5,459)

 

$ 69,697 


    Net income

--

 

-- 

 

10,858 

-- 

-- 

 

-- 

 

10,858 

    Dividends paid ($1.12 per share)

--

 

-- 

 

(6,897)

-- 

-- 

 

-- 

 

(6,897)

    Purchase of treasury stock

--

 

-- 

 

-- 

(3,483)

-- 

 

-- 

 

(3,483)

    Sale of treasury stock

--

 

-- 

 

-- 

12 

-- 

 

-- 

 

12 

    Director's deferred compensation, net

--

 

14 

 

-- 

268 

(144)

 

-- 

 

138 

    Shares issued under stock plans, net of
      excess tax benefit

--

 

(152)

 

-- 

322 

-- 

 

-- 

 

170 

    Stock option expense

--

 

16 

 

-- 

-- 

-- 

 

-- 

 

16 

    Dividend reinvestment plan

--

 

(27)

 

-- 

433 

353 

 

-- 

 

759 

    Other comprehensive loss

--

 

-- 

 

-- 

-- 

-- 

 

4,037 

 

4,037 


Balance at December 31, 2007

$67

 

$37,264 

 

$ 52,570 

$(19,214)

$6,042 

 

$(1,422)

 

$ 75,307 


 

See accompanying notes to consolidated financial statements.

<PAGE>  45

Merchants Bancshares, Inc.

Consolidated Statements of Cash Flows

For the Years Ended December 31,

2007      

2006      

2005      


(In thousands)

CASH FLOWS FROM OPERATING ACTIVITIES:

Net income

$ 10,858 

$ 10,871 

$   11,902 

Adjustments to reconcile net income to net cash provided by
  Operating activities:

    Provision for loan losses

1,150 

-- 

-- 

    Deferred tax (benefit) expense

(976)

(83)

1,364 

    Tax benefit from exercise of stock options

-- 

-- 

270 

    Depreciation and amortization

2,993 

4,073 

5,417 

    Stock option expense

16 

10 

-- 

    Net losses on investment securities

97 

464 

32 

    Gains from sales of loans, net

(150)

-- 

(74)

    Net losses on disposition of premises and equipment

10 

20 

    Net gains on sales of other real estate owned

(41)

-- 

-- 

    Equity in losses of real estate limited partnerships, net

1,744 

1,690 

1,760 

Changes in assets and liabilities:

    Decrease (increase) in interest receivable

108 

(268)

(129)

    (Increase) decrease in other assets

(1,619)

817 

159 

    Increase (decrease) in interest payable

238 

(544)

417 

    Increase (decrease) in other liabilities

1,187 

1,161 

(205)


            Net cash provided by operating activities

15,615 

18,199 

20,933 


CASH FLOWS FROM INVESTING ACTIVITIES:

    Proceeds from sales of investment securities available for sale

6,417 

22,024 

18,636 

    Proceeds from maturities of investment securities available for sale

71,013 

77,146 

94,077 

    Proceeds from maturities of investment securities held to maturity

1,539 

2,053 

11,862 

    Proceeds from redemption of Federal Home Loan Bank stock

372 

3,872 

-- 

    Purchases of investment securities available for sale

(100,417)

(51,047)

(148,662)

    Loan originations in excess of principal payments

(43,894)

(83,470)

(24,995)

    Purchases of Federal Home Loan Bank stock

-- 

(462)

(1,349)

    Proceeds from sales of loans, net

1,262 

-- 

3,060 

    Proceeds from sales of premises and equipment

-- 

-- 

272 

    Proceeds from sales of other real estate owned

299 

54 

-- 

    Proceeds from sale of real estate limited partnership investment

1,141 

-- 

-- 

    Real estate limited partnership investments

(36)

(1,254)

(2,533)

    Gain on sale of real estate limited partnership investment

(259)

-- 

-- 

    Purchases of bank premises and equipment

(846)

(2,481)

(1,808)


            Net cash used in investing activities

(63,409)

(33,565)

(51,440)


CASH FLOWS FROM FINANCING ACTIVITIES:

    Net (decrease) increase in deposits

(9,915)

22,776 

20,412 

    Net decrease in short-term borrowings

(1,833)

(48,988)

(4,386)

    Proceeds from long-term debt

23,825 

30,000 

45,000 

    Net increase in securities sold under agreement to
      repurchase-short term

10,203 

86,547 

20,000 

    Net increase in securities sold under agreement to repurchase-long term

21,500 

-- 

-- 

    Principal payments on long-term debt

(15,571)

(31,901)

(38,993)

    Cash dividends paid

(6,138)

(6,203)

(6,039)

    Purchases of treasury stock

(3,483)

(3,993)

(4,474)

    Sale of treasury stock

12 

11 

3,567 

    Increase in deferred compensation arrangements

138 

258 

234 

    Proceeds from exercise of stock options

155 

231 

75 

    Tax benefit from exercise of stock options

15 

120 

-- 


            Net cash provided by financing activities

18,908 

48,858 

35,396 


(Decrease) increase in cash and cash equivalents

(28,886)

33,492 

4,889 

Cash and cash equivalents beginning of year

78,706 

45,214 

40,325 


Cash and cash equivalents end of period

$ 49,820 

$ 78,706 

$   45,214 


SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:

    Total interest payments

$ 26,148 

$ 23,833 

$   13,457 

    Total income tax payments

3,800 

2,322 

860 

SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES

    Distribution of stock under deferred compensation arrangements

268 

282 

271 

    Distribution of treasury stock in lieu of cash dividend

759 

834 

792 

    Transfer of loans to other real estate owned

475 

312 

-- 

See accompanying notes to consolidated financial statements.

<PAGE>  46

Merchants Bancshares, Inc.

Notes to Consolidated Financial Statements

December 31, 2007, 2006 and 2005

 

(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Principles of Consolidation

The accompanying consolidated financial statements include the accounts of Merchants Bancshares, Inc. and its wholly owned subsidiary Merchants Bank and Merchants Properties, Inc., as well as Merchants Bank's wholly owned subsidiary Merchants Trust Company (collectively "Merchants"). All material intercompany accounts and transactions are eliminated in consolidation. Merchants Bank and Merchants Trust Company offer a full range of deposit, loan, cash management, and trust services to meet the financial needs of individual consumers, businesses and municipalities at 36 full-service banking offices throughout the state of Vermont.

 

Management's Use of Estimates in Preparation of Financial Statements

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of income and expenses during the reporting periods. The most significant estimates include those used in determining the allowance for loan losses, income taxes, and interest income recognition on loans and investments. Operating results in the future may vary from the amounts derived from management's estimates and assumptions.

 

Cash and Cash Equivalents

Cash and cash equivalents consist of cash on hand, amounts due from banks, Federal Funds sold and other short-term investments in the accompanying consolidated statements of cash flows.

 

Investment Securities

Merchants classifies certain of its investments in debt securities as held to maturity, which are carried at amortized cost, if Merchants has the positive intent and ability to hold such securities to maturity. Investments in debt securities that are not classified as held to maturity and equity securities that have readily determinable fair values are classified as available for sale securities or trading securities. Trading securities are investments purchased and held principally for the purpose of selling in the near term; available for sale securities are investments not classified as trading or held to maturity. Available for sale securities are carried at fair value which is measured at each reporting date. The resulting unrealized gain or loss is reflected in accumulated other comprehensive income (loss) net of the associated tax effects. Gains and losses on sales of investment securities are recognized through the statement of income using the specific identification method.

 

Transfers from securities available for sale to securities held to maturity are recorded at the securities' fair values on the date of the transfer. Any net unrealized gains or losses continue to be included as a separate component of accumulated other comprehensive income (loss), on a net of tax basis. As long as the securities are carried in the held to maturity portfolio, such amounts are amortized (accreted) over the estimated remaining life of the transferred securities as an adjustment to yield in a manner consistent with the amortization of premiums and discounts.

 

Interest and dividend income, including amortization of premiums and discounts, are recorded in earnings for all categories of investment securities. Discounts and premiums related to debt securities are amortized using the level-yield method.

 

Management reviews reductions in fair value below book value of investment securities to determine whether the impairment is other than temporary. If the impairment is determined to be other than temporary in nature, the carrying value of the security is written down to the appropriate level by a charge to earnings in the period of determination.

<PAGE>  47

Federal Home Loan Bank Stock

As a member of the Federal Home Loan Bank of Boston ("FHLB"), Merchants is required to hold stock in the FHLB. FHLB stock is carried at cost since there is no readily available market value. The stock cannot be sold, but can be redeemed by the FHLB at cost.

 

Loans

Loans are carried at the principal amounts outstanding net of the allowance for loan losses, and net of deferred loan costs and fees. Deferred loan costs and fees are amortized over the estimated lives of the loans using the interest method.

 

Allowance for Credit Losses

The Allowance for Credit Losses ("Allowance") is comprised of the Allowance for Loan Losses and the Reserve for Undisbursed Lines of Credit, and is based on management's estimate of the amount required to reflect the known and inherent risks in the loan portfolio. The Allowance is based on management's systematic periodic review of the collectibility of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower's ability to repay, estimated value of any underlying collateral and prevailing economic conditions.

 

In addition, Federal regulatory agencies, as an integral part of their examination process, periodically review Merchants' Allowance and may require Merchants to recognize additions to the Allowance based on their judgments about information available to them at the time of their examination, which may not be currently available to management.

 

Factors considered in evaluating the adequacy of the Allowance include previous loss experience, the size and composition of the portfolio, current economic and real estate market conditions and their effect on the borrowers, the performance of individual loans in relation to contract terms, and estimated fair market values of collateral properties.

 

A loan is considered impaired when it is probable that Merchants will be unable to collect all principal and interest due according to the contractual terms of the loan agreement. This treatment does not apply to large groups of smaller-balance homogenous loans that are collectively evaluated for impairment, such as residential mortgage and consumer loans. When a loan is impaired, Merchants measures an impairment loss equal to the excess, if any, of the loan's carrying amount over (1) the present value of expected future cash flows discounted at the loans original effective interest rate, (2) the observable market price of the impaired loan, or (3) the fair value of the collateral securing a collateral-dependent loan. When a loan is deemed to have an impairment loss, a valuation allowance is established as part of the overall allowance for loan losses. The bank recognizes interest income on impaired loans consistent with its nonaccrual policy for loans generally.

 

Income Recognition on Impaired and Nonaccrual Loans

Loans, including impaired loans, are generally classified as nonaccrual if they are past due as to maturity or payment of principal or interest for a period of more than 90 days, unless such loans are well-collateralized and in the process of collection. If a loan or a portion of a loan is internally classified as doubtful or is partially charged-off, the loan is classified as nonaccrual. Loans that are on a current payment status or past due less than 90 days may also be classified as nonaccrual if repayment in full of principal and/or interest is in doubt.

 

Loans may be returned to accrual status when all principal and interest amounts contractually due, including arrearages, are reasonably assured of repayment within an acceptable period of time, and there is a sustained period of repayment performance (generally a minimum of six months) by the borrower, in accordance with the contractual terms of the loans.

 

While a loan is classified as nonaccrual and the future collectibility of the recorded loan balance is uncertain, any payments received are generally applied to reduce the principal balance. When the future collectibility of the recorded loan balance is expected, interest income may be recognized on a cash basis. In the case where a nonaccrual loan had been partially charged-off, recognition of interest on a cash basis is limited to that which would have been recognized on the recorded loan balance at the contractual interest rate. Interest collections in excess of that amount are recorded as recoveries to the Allowance until prior charge-offs have been fully recovered.

<PAGE>  48

Premises and Equipment

Premises and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation and amortization are provided using straightline and accelerated methods at rates that depreciate the original cost of the premises and equipment over their estimated useful lives. Expenditures for maintenance, repairs and renewals of minor items are generally charged to expense as incurred. When premises and equipment are replaced, retired, or deemed no longer useful they are written down to estimated selling price less costs to sell by a charge to current earnings.

 

Income Taxes

Deferred tax assets and liabilities are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. Low-income housing tax credits and historic rehabilitation credits are recognized as a reduction of income tax expense in the year in which they are earned. Interest and penalties for 2007 and 2006 were insignificant and were classified as other noninterest expense in Merchants' consolidated statement of income.

 

Investments in Real Estate Limited Partnerships

Merchants has investments in various real estate limited partnerships that acquire, develop, own and operate low and moderate-income housing. Merchants' ownership interest in these limited partnerships ranges from 3.3% to 99% as of December 31, 2007. Merchants accounts for its investments in limited partnerships, where Merchants neither actively participates nor has a controlling interest, under the equity method of accounting. During 2007, Merchants sold the only limited partnership in which it was a general partner. Prior to the sale, Merchants consolidated the financial statements of the limited partnership as it was the general partner, was actively involved in management, and had a controlling interest.

 

Management periodically reviews the results of operations of the various real estate limited partnerships to determine if the partnerships generate sufficient operating cash flow to fund their current obligations. In addition, management reviews the current value of the underlying property compared to the outstanding debt obligations. If it is determined that the investment suffers from a permanent impairment, the carrying value is written down to the estimated realizable value. The maximum exposure on these investments is the current carrying amount plus amounts obligated to be funded in the future.

 

Other Real Estate Owned

Collateral acquired through foreclosure is recorded at the lower of cost or fair value, less estimated costs to sell, at the time of acquisition. Subsequent decreases in the fair value of other real estate owned ("OREO") are reflected as a write-down and charged to expense. Net operating income or expense related to foreclosed property is included in noninterest expense in the accompanying consolidated statements of income.

 

Intangible Assets

Premiums paid for the purchase of core deposits are recorded as other assets and amortized using straight-line and accelerated methods over 7 to 15 years. As of December 31, 2007, such intangible assets totaled approximately $93 thousand and are included in other assets on the consolidated balance sheets.

 

Stock-Based Compensation

Merchants has granted stock options to certain key employees. The options are exercisable immediately after the vesting period. Stock options may be granted at any price determined by the Nominating and Governance Committee of Merchants' Board of Directors. All stock options have been granted at or above fair market value at the date of grant.

 

Effective January 1, 2006, Merchants adopted the provisions of Statement of Financial Accounting Standards ("SFAS") No. 123R, "Share-Based Payment," using a modified prospective application. The fair value of each option grant is estimated on the grant date using the Black-Scholes option-pricing model that requires Merchants to develop estimates for assumptions used in the model. The Black-Scholes valuation model uses the following assumptions: expected volatility, expected term of option, risk-free interest rate and dividend yield. Expected volatility estimates are

<PAGE>  49

developed by Merchants based on historical volatility of Merchants' stock. Merchants uses historical data to estimate the expected term of the options. The risk-free interest rate for periods within the expected life of the option is based on the U.S. Treasury yield in effect at the grant date.

 

Employee Benefit Costs

Prior to 1995 Merchants maintained a non-contributory pension plan covering substantially all employees that met eligibility requirements. The plan was curtailed in 1995. The cost of this plan, based on actuarial computations of current and future benefits, is charged to current operating expenses. Effective December 31, 2006, Merchants adopted SFAS No. 158, "Employers' Accounting for Defined Benefit Pension and Other Post Retirements Plans - An Amendment of Financial Accounting Standards Board ("FASB") Statements No. 87, 88, 106 and 132 (R)", which requires the recognition of the overfunded or underfunded status of a single employer defined benefit post retirement plan as an asset or liability on the consolidated balance sheets and to recognize changes in the funded status in comprehensive income in the year in which the change occurred. However, gains or losses, prior service costs or credits, and transition assets or obligations that have not yet been included in net periodic benefit costs as of the end of 2006, the fiscal year in which SFAS No. 158 is initially applied, are to be recognized as components of the ending balance of accumulated other comprehensive income, net of tax, subsequent to December 31, 2006.

 

Earnings Per Share

Basic earnings per share are calculated by dividing net income available to common shareholders by the weighted average number of common shares outstanding. Diluted earnings per share are computed in a manner similar to that of basic earnings per share except that the weighted average number of common shares outstanding is increased to include the number of additional common shares that would have been outstanding if all potentially dilutive common shares (such as stock options and unvested restricted stock awards) were issued during the period, computed using the treasury stock method.

 

Derivative Financial Instruments and Hedging Activities

Derivative instruments utilized by Merchants have included interest rate floor, cap and swap agreements. Merchants is an end-user of derivative instruments and does not conduct trading activities for derivatives.

 

Merchants follows the provisions of SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the balance sheet and measure those instruments at fair value. Changes in the fair value of the derivative financial instruments are reported in either net income or as a component of other comprehensive income, depending on the use of the derivative and whether or not it qualifies for hedge accounting.

 

Segment Reporting

Merchants' operations are solely in the financial services industry and include providing to its customers traditional banking and other financial services. Merchants operates primarily in the state of Vermont. Management makes operating decisions and assesses performance based on an ongoing review of Merchants' consolidated financial results. Therefore, Merchants has a single operating segment for financial reporting purposes.

 

Recent Accounting Pronouncements

In December 2007, the FASB issued revised SFAS No. 141, "Business Combinations," or SFAS No. 141(R). SFAS No. 141(R) retains the fundamental requirements of SFAS No. 141 that the acquisition method of accounting (formerly the purchase method) be used for all business combinations; that an acquirer be identified for each business combination; and that intangible assets be identified and recognized separately from goodwill. SFAS No. 141(R) requires the acquiring entity in a business combination to recognize the assets acquired, the liabilities assumed and any non-controlling interest in the acquiree at the acquisition date, measured at their fair values as of that date, with limited exceptions. Additionally, SFAS No. 141(R) changes the requirements for recognizing assets acquired and liabilities assumed arising from contingencies and recognizing and measuring contingent consideration. SFAS No. 141(R) also enhances the disclosure requirements for business combinations. SFAS No. 141(R) applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008 and may not be applied before that date.

<PAGE>  50

In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities, Including an amendment of FASB Statement No. 115," which permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. At the effective date, an entity may elect the fair value option for eligible items that exist at that date and report the effect of the first re-measurement to fair value as a cumulative-effect adjustment to the opening balance of retained earnings. Subsequent to the effective date, unrealized gains and losses on items for which the fair value option has been elected are to be reported in earnings. If the fair value option is elected for any available-for-sale or held-to-maturity securities at the effective date, cumulative unrealized gains and losses at that date are included in the cumulative-effect adjustment and those securities are to be reported as trading securities under SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," but the accounting for a transfer to the trading category under SFAS No. 115 does not apply. Electing the fair value option for an existing held-to-maturity security will not call into question the intent of an entity to hold other debt securities to maturity in the future. SFAS No. 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. SFAS No. 159 does not affect any existing accounting literature that requires certain assets and liabilities to be carried at fair value and does not eliminate disclosure requirements included in other accounting standards. SFAS No. 159 is effective as of the beginning of an entity's first fiscal year that begins after November 15, 2007. Early adoption was permitted; however, we did not elect early adoption and therefore adopted the standard as of January 1, 2008. Upon adoption, we did not elect the fair value option for eligible items that existed at January 1, 2008.

 

In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements," which defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. The expanded disclosures include a requirement to disclose fair value measurements according to a hierarchy, segregating measurements using (1) quoted prices in active markets for identical assets and liabilities, (2) significant other observable inputs and (3) significant unobservable inputs. SFAS No. 157 applies only to fair value measurements already required or permitted by other accounting standards and does not impose requirements for additional fair value measures. SFAS No. 157 was issued to increase consistency and comparability in reporting fair values. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The provisions are to be applied prospectively as of the beginning of the fiscal year in which the statement is initially applied, with certain exceptions. A transition adjustment, measured as the difference between the carrying amounts and the fair values of certain specific financial instruments at the date SFAS No. 157 is initially applied, is to be recognized as a cumulative-effect adjustment to the opening balance of retained earnings for the fiscal year in which SFAS No. 157 is initially applied. SFAS No. 157 will affect certain of our fair value disclosures, but is not expected to have a material impact on our financial condition or results of operations.

 

Reclassifications

Reclassifications are made to prior years' consolidated financial statements whenever necessary to conform to the current year's presentation.

<PAGE>  51

(2) INVESTMENT SECURITIES

 

Investments in securities are classified as available for sale or held to maturity as of December 31, 2007 and 2006. The amortized cost and fair values of the securities classified as available for sale and held to maturity as of December 31, 2007 and 2006 are as follows:

 

SECURITIES AVAILABLE FOR SALE:

 

(In thousands)

 

Amortized
Cost

 

Gross
Unrealized
Holding
Gains

 

Gross
Unrealized
Holding
Losses

 

Fair
Value


2007

               

    U.S. Treasury Obligations

 

$       250

 

$       5

 

$       --

 

$       255

    U.S. Agency Obligations

 

15,750

 

91

 

1

 

15,840

    Residential Real Estate Mortgage-backed
      Securities

164,072

1,075

583

164,564

    Commercial Real Estate Mortgage-backed
      Securities

 

36,396

 

9

 

322

 

36,083

    Collateralized Mortgage Obligations

 

122,453

 

447

 

763

 

122,137

    Corporate Bonds

 

14,298

 

96

 

78

 

14,316

    Asset Backed Securities

 

8,402

 

2

 

87

 

8,317


   

$361,621

 

$1,725

 

$1,834

 

$361,512


 

(In thousands)

 

Amortized
Cost

 

Gross
Unrealized
Holding
Gains

 

Gross
Unrealized
Holding
Losses

 

Fair
Value


2006

               

    U.S. Treasury Obligations

 

$       200

 

$    --

 

$       1

 

$       199

    U.S. Agency Obligations

 

21,739

 

135

 

115

 

21,759

    Residential Real Estate Mortgage-backed
      Securities

 


122,509

 


217

 


2,260

 


120,466

    Commercial Real Estate Mortgage-backed
      Securities

 


48,655

 


--

 


1,089

 


47,566

    Collateralized Mortgage Obligations

 

111,375

 

44

 

2,099

 

109,320

    Corporate Bonds

 

23,151

 

8

 

350

 

22,809

    Asset Backed Securities

 

11,995

 

9

 

165

 

11,839


   

$339,624

 

$413

 

$6,079

 

$333,958


 

SECURITIES HELD TO MATURITY:

 

(In thousands)

 

Amortized
Cost

 

Gross
Unrealized
Holding
Gains

 

Gross
Unrealized
Holding
Losses

 

Fair
Value


2007

               

Residential Real Estate Mortgage-backed
  Securities

 

$4,078

 

$205

 

$--

 

$4,283


   

$4,078

 

$205

 

$--

 

$4,283


 

(In thousands)

 

Amortized
Cost

 

Gross
Unrealized
Holding
Gains

 

Gross
Unrealized
Holding
Losses

 

Fair
Value


2006

               

Residential Real Estate Mortgage-backed
  Securities

 

$5,615

 

$189

 

$--

 

$5,804


   

$5,615

 

$189

 

$--

 

$5,804


 
 

There were no securities classified as trading at December 31, 2007 and 2006.

<PAGE>  52

The contractual final maturity distribution of the debt securities classified as available for sale and held to maturity as of December 31, 2007, are as follows:

 

SECURITIES AVAILABLE FOR SALE:

 

(In thousands)

Within
One Year

After One
But Within
Five Years

After Five
But Within
Ten Years

After Ten
Years

Total


U.S. Treasury Obligations

$       --

 

$     255

 

$         --

 

$           --

 

$       255

U.S. Agency Obligations

4,022

 

11,818

 

--

 

--

 

15,840

Residential Real Estate Mortgage-backed
  Securities

2,012

19,694

39,580

103,278

164,564

Commercial Real Estate Mortgage-backed
  Securities

--

1,881

--

34,202

36,083

Collateralized Mortgage Obligations

--

 

5,337

 

14,170

 

102,630

 

122,137

Corporate Bonds

3,249

 

8,638

 

2,429

 

--

 

14,316

Asset Backed Securities

--

 

2,493

 

--

 

5,824

 

8,317


 

$9,283

 

$50,116

 

$56,179

 

$245,934

 

$361,512


 

SECURITIES HELD TO MATURITY:

 

(In thousands)

Within
One Year

After One
But Within
Five Years

After Five
But Within
Ten Years

After Ten
Years

Total


Residential Real Estate Mortgage-backed
  Securities

$23

$864

$2,244

$947

$4,078


 

Actual maturities will differ from contractual maturities because borrowers may have rights to call or prepay obligations. Maturities of mortgage-backed securities and collateralized mortgage obligations are based on final contractual maturities.

 

Proceeds from sales of available for sale debt securities were $6.42 million, $22.02 million and $18.64 million during 2007, 2006 and 2005, respectively. Gross gains of zero, zero and $121 thousand; and gross losses of $97 thousand, $464 thousand and $153 thousand were realized from sales of securities in 2007, 2006 and 2005, respectively.

 

Securities with a book value of $174.32 million and $152.20 million at December 31, 2007 and 2006, respectively, were pledged to secure U.S. Treasury borrowings, public deposits, securities sold under agreements to repurchase, and for other purposes required by law.

 

Gross unrealized losses on investment securities available for sale and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in continuous unrealized loss position, at December 31, 2007, were as follows:

<PAGE>  53

 

Less Than 12 Months

 

12 Months or More

 

Total

(In thousands)

Fair
Value

Unrealized
Losses

Fair
Value

Unrealized
Losses

Fair
Value

Unrealized
Losses


U.S. Treasury Obligations

$         --

 

$    --

 

$           --

 

$       --

 

$           --

 

$       --

U.S. Agency Obligations

--

 

--

 

3,996

 

1

 

3,996

 

1

Residential Real Estate
  Mortgage-backed Securities

2,046

10

52,532

573

54,578

583

Commercial Real Estate
  Mortgage-backed Securities

2,030

1

29,279

321

31,309

322

Collateralized Mortgage Obligations

6,026

 

80

 

63,777

 

683

 

69,803

 

763

Corporate Bonds

983

 

15

 

6,663

 

62

 

7,646

 

77

Asset Backed Securities

--

 

--

 

7,854

 

88

 

7,854

 

88


 

$11,085

 

$106

 

$164,101

 

$1,728

 

$175,186

 

$1,834


 

<PAGE>  53

Gross unrealized losses on investment securities available for sale and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in continuous unrealized loss position, at December 31, 2006, were as follows:

 
 

Less Than 12 Months

 

12 Months or More

 

Total

(In thousands)

Fair
Value

Unrealized
Losses

Fair
Value

Unrealized
Losses

Fair
Value

Unrealized
Losses


U.S. Treasury Obligations

$         --

 

$    --

 

$       199

 

$       1

 

$       199

 

$       1

U.S. Agency Obligations

4,978

 

13

 

7,888

 

102

 

12,866

 

115

Residential Real Estate
  Mortgage-backed Securities

--

--

93,071

2,260

93,071

2,260

Commercial Real Estate
  Mortgage-backed Securities

7,395

39

40,171

1,050

47,566

1,089

Collateralized Mortgage Obligations

5,361

 

20

 

98,716

 

2,079

 

104,077

 

2,099

Corporate Bonds

--

 

--

 

20,804

 

350

 

20,804

 

350

Asset Backed Securities

2,658

 

14

 

7,153

 

151

 

9,811

 

165


 

$20,392

 

$86

 

$268,002

 

$5,993

 

$288,394

 

$6,079


 

There were no securities held to maturity with unrealized losses as of December 31, 2007 and 2006.

 

Unrealized losses on investment securities result from the cost basis of the security being higher than its current fair market value. These discrepancies generally occur because of changes in interest rates since the time of purchase, or because the credit quality of the issuer has deteriorated. Merchants performs a quarterly analysis of each security in its portfolio to determine if impairment exists, and if it does, whether that impairment is other than temporary. Current accounting literature requires that Merchants must demonstrate an ability and intent to hold impaired securities until full recovery of their cost basis. The ability to hold the impaired securities is primarily dependent on Merchants' current capital and liquidity position. Merchants currently intends to hold all temporarily impaired securities to full recovery, which may be until final maturity.

 

At December 31, 2007 Merchants had securities with a fair value of $164.10 million that had been impaired for twelve months or longer due to interest rates currently being higher than at the time of purchase. The total unrealized loss on these securities was $1.73 million at December 31, 2007, a decline of $4.26 million from the December 31, 2006 unrealized loss of $5.99 million. Of the $164.10 million, $4.00 million consists of an agency security that is currently performing as expected; $116.31 million of these impaired securities consisted of residential mortgage-backed securities and collateralized mortgage obligations that carry AAA ratings or Agency-implied AAA credit ratings, and are currently performing as expected. Merchants does not consider these securities to be other than temporarily impaired and has the intent and ability to hold these investments until a market price recovery which could be maturity.

 

At December 31, 2007 Merchants had 16 commercial mortgage-backed securities ("CMBS") with a fair value of $29.28 million that had been impaired for twelve months or longer. These bonds are all rated AAA and are backed by a variety of types of commercial real estate. Merchants looks at the overall structure of these bonds for, among other things, low historical default rates, low loan-to-value ratios, prepayment penalties and lock-outs, and good geographic and property type diversity as part of its pre-purchase evaluation. Merchants does not consider these securities to be other than temporarily impaired and has the intent and ability to hold these investments until a market price recovery which could be maturity.

 

Merchants had five corporate bonds with a fair value of $6.66 million that had been impaired for twelve months or longer. These losses were caused by interest rate fluctuations. The bonds in this asset class are rated A- to AAA. Additionally, Merchants had four asset-backed securities with a fair value of $7.85 million that had been impaired for twelve months or longer. The bonds in this asset class carry AAA ratings and are currently performing as expected. Merchants does not consider these securities to be other than temporarily impaired and has the intent and ability to hold these investments until a market price recovery which could be maturity.

<PAGE>  54

(3) LOANS

 

The composition of the loan portfolio at December 31, 2007 and 2006 is as follows:

 
 

(In thousands)

2007     

 

2006     

 
 


 
 

Commercial, Financial and Agricultural

$  92,740

 

$  73,512

 
 

Real Estate - Residential

356,472

 

323,885

 
 

Real Estate - Commercial

234,675

 

250,526

 
 

Real Estate - Construction

39,347

 

33,167

 
 

Installment Loans to individuals

7,220

 

7,133

 
 

All Other Loans (including overdrafts)

1,054

 

1,060

 
 


 
 

Total Loans

$731,508

 

$689,283

 
 


 
     

At December 31, 2007 and 2006, total loans included $22 thousand and $95 thousand, respectively, of net deferred loan fees. The aggregate amount of overdrawn deposit balances classified as loan balances was $1.05 million and $1.06 million at December 31, 2007 and 2006, respectively.

 

Residential and commercial loans serviced for others at December 31, 2007 and 2006 amounted to approximately $10.68 million and $11.5 million, respectively.

 

Merchants primarily originates residential real estate, commercial, commercial real estate, and installment loans to customers throughout the state of Vermont. There are no significant industry concentrations in the loan portfolio. There was significant disruption and volatility in the financial and capital markets during the second half of 2007. Turmoil in the mortgage market adversely impacted the domestic markets, and led to a significant credit and liquidity crisis. These market conditions were attributable to a variety of factors, in particular the fallout associated with subprime mortgage loans (a type of lending Merchants has never actively pursued). The disruption has been exacerbated by the continued decline of the real estate and housing markets. While continuing to adhere to prudent underwriting standards, Merchants is not immune to some negative consequences arising from overall economic weakness and, in particular, a sharp downturn in the housing market in Vermont. Decreases in real estate values could adversely affect the value of property used as collateral for loans. Adverse changes in the economy may have a negative effect on the ability of Merchants' borrowers to make timely loan payments, which would have an adverse impact on earnings. An increase in loan delinquencies would decrease net interest income and adversely impact loan loss experience, causing increases in the provision and allowance for loan losses.

 

A summary of changes in the allowance for credit losses for the years ended December 31, 2007, 2006 and 2005 is as follows:

 
 

(In thousands)

2007   

 

2006   

 

2005   

 
 


 
 

Balance, Beginning of Year

$7,281 

 

$7,083 

 

$7,512 

 
 

Provision for Loan Losses

1,150 

 

-- 

 

-- 

 
 

Loans Charged Off

(432)

 

(63)

 

(693)

 
 

Recoveries

351 

 

261 

 

264 

 
 


 
 

Balance, End of Year

$8,350 

 

$7,281 

 

$7,083 

 
 


 
     

Components:

 
 

Allowance for Loan Losses

$8,002 

 

$6,911 

 

$7,083 

 
 

Reserve for Undisbursed Lines of Credit (1)

348 

 

370 

 

-- 

 
 


 
 

Allowance for Credit Losses

$8,350 

 

$7,281 

 

$7,083 

 
 


 
 

(1)

Effective March 31, 2006 Merchants transferred the portion of the allowance for loan losses related to undisbursed lines of credit to other liabilities.

<PAGE>  55

Impaired loans consist primarily of large, nonaccrual, construction, commercial and commercial real estate loans. Total impaired loans were approximately $8.87 million, $2.29 million and $2.01 million at December 31, 2007, 2006 and 2005, respectively. At December 31, 2007 $7.20 million of the impaired loans had a specific reserve allocation of $614 thousand, and $1.67 million of the impaired loans had no specific reserve allocation. At December 31, 2006, $377 thousand of the impaired loans had a specific reserve allocation of $37 thousand and $1.92 million of the impaired loans had no specific reserve allocation. At December 31, 2005 there was no specific reserve allocation. Interest payments on impaired loans are generally recorded as principal reductions if the remaining loan balance is not expected to be paid in full. If full collection of the remaining loan balance is expected, interest income is recognized on a cash basis. Merchants recorded interest income on impaired loans of approximately $21 thousand, $12 thousand and $18 thousand and during 2007, 2006 and 2005, respectively. The average balance of impaired loans was $5.9 million in 2007, $2.0 million in 2006 and $3.3 million in 2005.

 

Nonperforming loans at December 31, 2007 and 2006 are as follows:

 
 

(In thousands)

2007 

 

2006 

 
 


 
 

Nonaccrual loans

$9,018

 

$2,606

 
 

Restructured loans

156

 

92

 
 

90 days past due and still accruing interest

57

 

--

 
 


 
 

Total nonperforming loans

$9,231

 

$2,698

 
 


 
     

The above disclosed restructured loans were performing in accordance with modified agreements with the borrowers at December 31, 2007 and 2006. Merchants recorded interest income on restructured loans of approximately $8 thousand for 2007. There are no commitments to lend additional funds to borrowers whose loans have been modified in a troubled debt restructuring. Merchants had $806 thousand in commitments to lend additional funds to borrowers whose loans were nonperforming at December 31, 2007. Merchants' Other Real Estate Owned balance was $475 thousand at December 31, 2007 and $258 thousand at December 31, 2006.

 

The amount of interest which was not earned, but which would have been earned had Merchants' nonaccrual and restructured loans performed in accordance with their original terms and conditions, was approximately $475 thousand, $225 thousand and $181 thousand in 2007, 2006 and 2005, respectively.

 

An analysis of loans to directors, executive officers, and associates of such persons for the year ended December 31, 2007, is as follows:

 
 

(In thousands)

   
 


 
 

Balance, December 31, 2006

$3,366 

 
 

Additions

648 

 
 

Repayments

(498)

 
 

Other repayments (1)

(189)

 
 


 
 

Balance, December 31, 2007

$3,327 

 
 


 
     

(1)

Other repayments pertain to a change in executive officers

 

It is the policy of Merchants to make loans to directors, executive officers, and associates of such persons on substantially the same terms, including interest rates and collateral, as those prevailing for comparable lending transactions with other persons.

<PAGE>  56

(4) PREMISES AND EQUIPMENT

 

The components of premises and equipment included in the accompanying consolidated balance sheets are as follows:

2007   

2006   

Estimated
Useful Lives

 


 
   

    (In Thousands)

 

(In Years)

 
 

Land

$     757

 

$     757

 

N/A

 
 

Bank Premises

14,021

 

13,860

 

39

 
 

Leasehold Improvements

3,691

 

3,675

 

5 - 20

 
 

Furniture, Equipment and Software

14,297

 

14,209

 

3 - 7

 
 


 
   

32,766

 

32,501

     
 

Less: Accumulated Depreciation and Amortization

21,282

 

19,963

     
 


 
   

$11,484

 

$12,538

     
 


 
               

Depreciation and amortization expense related to premises and equipment amounted to $1.89 million, $2.07 million and $2.20 million in 2007, 2006 and 2005, respectively.

 

Merchants occupies certain banking offices under noncancellable operating lease agreements expiring at various dates over the next 20 years. The majority of leases have multiple options with escalation clauses for increases associated with the cost of living or other variable expenses over time. Rent expense on these properties totaled $667 thousand, $657 thousand and $561 thousand for the years ended December 31, 2007, 2006 and 2005, respectively. Minimum lease payments on these properties subsequent to December 31, 2007 are as follows: 2008 - $771 thousand; 2009 - $782 thousand; 2010 - $729 thousand; 2011 - $665 thousand; 2012 - $604 thousand and $3.10 million thereafter.

 

Amortization of intangible assets amounted to $186 thousand, $303 thousand and $327 thousand in 2007, 2006 and 2005, respectively. Amortization for these intangibles is $93 thousand for 2008 and is zero thereafter.

 

(5) TIME DEPOSITS

 

Scheduled maturities of time deposits at December 31, 2007 were as follows:

 
 

(In thousands)

   
 


 
 

Mature in year ending December 31,

   
 

    2008

$308,461

 
 

    2009

14,005

 
 

    2010

4,417

 
 

    2011

2,970

 
 

    2012

2,919

 
 

    Thereafter

--

 
 


 
 

Total time deposits

$332,772

 
 


 
     

Time deposits greater than $100 thousand totaled $85.74 million and $76.82 million as of December 31, 2007 and 2006, respectively. Interest expense on time deposits greater than $100 thousand amounted to $2.82 million, $2.03 million and $1.14 million for the years ended December 31, 2007, 2006 and 2005, respectively.

<PAGE>  57

(6) SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE AND OTHER SHORT-TERM DEBT

 

Securities sold under agreements to repurchase and other short-term debt consisted of the following at December 31, 2007 and 2006:

 
 

(In thousands)

2007   

 

2006   

 
 


 
 

Demand Note Due U.S. Treasury

$  2,167

 

$  4,000

 
 

Securities Sold Under Agreements to Repurchase

96,750

 

86,547

 
 


 
   

$98,917

 

$90,547

 
 


 
           

The Demand Note Due U.S. Treasury matures daily and bears interest at the federal funds rate less .25%; the rate on this borrowing at December 31, 2007 was 4.0%. The Securities Sold Under Agreements to Repurchase are collateralized by mortgage backed securities and collateralized mortgage-backed obligations. The repurchase agreements mature daily, the average rate paid on these funds for 2007 was 3.41%. The carrying value of the securities sold under repurchase agreements was $113.36 million and the market value was $113.50 million at December 31, 2007.

 

As of December 31, 2007, Merchants could borrow up to $49 million in overnight funds. $44 million of this $49 million is unsecured borrowing lines established with correspondent banks; the balance of $5 million is in the form of an overnight line of credit with the FHLB. Merchants has established both overnight and longer term lines of credit with the FHLB. The borrowings are secured by mortgage loans. The total amount of loans pledged to the FHLB for both short and long-term borrowing arrangements totaled $254.94 million and $232.65 million at December 31, 2007 and 2006, respectively.

 

The following table provides certain information regarding other borrowed funds for the three years ended December 31, 2007, 2006 and 2005:

 

 

(In thousands)

2007   

 

2006   

 

2005   

 
 


 
 

Federal Home Loan Bank Short-term Borrowings

           
 

    Amount outstanding at year end

$        --   

 

$        --   

 

$50,000   

 
 

    Maximum Month-End Amount Outstanding

--   

 

98,000   

 

60,000   

 
 

    Average Amount Outstanding

--   

 

43,911   

 

44,321   

 
 

    Weighted Average-Rate During The Year

--   

 

4.88%

 

3.34%

 
 

    Weighted Average-Rate at Year-end

--   

 

--   

 

4.02%

 
 


 
 

Demand Note Due U.S. Treasury

           
 

    Amount outstanding at year end

$  2,167   

 

$  4,000   

 

$  2,988   

 
 

    Maximum Month-End Amount Outstanding

4,000   

 

4,000   

 

3,976   

 
 

    Average Amount Outstanding

1,559   

 

1,306   

 

1,137   

 
 

    Weighted Average-Rate During The Year

4.90%

 

4.75%

 

3.09%

 
 

    Weighted Average-Rate at Year-end

3.59%

 

5.04%

 

3.95%

 
 


 
 

Securities Sold Under Agreement to Repurchase

           
 

    Amount outstanding at year end

$96,750   

 

$86,547   

 

$        --   

 
 

    Maximum Month-End Amount Outstanding

98,797   

 

99,606   

 

--   

 
 

    Average Amount Outstanding

83,482   

 

42,012   

 

--   

 
 

    Weighted Average-Rate During The Year

4.10%

 

4.42%

 

--   

 
 

    Weighted Average-Rate at Year-end

3.41%

 

4.34%

 

--   

 
 


 
               

<PAGE>  58

(7) LONG-TERM DEBT

 

Long-term debt consisted of the following at December 31, 2007 and 2006:

           
 

(In thousands)

2007   

 

2006   

 
 


 

Federal Home Loan Bank Notes,
  Rates ranging from 2.41% to 5.13%
  Payable March 2008 through March 2010

$  60,522

$51,914

Amortizing Federal Home Loan Bank Notes, payable through
  October 2023, Rates ranging from 1.50% to 2.25%

1,595

802

Securities Sold Under Agreements to Repurchase, payable
  December 2008, variable rate

20,000

20,000

Securities Sold Under Agreements to Repurchase, payable October through
  December 2012, rates ranging from 3.76% to 4.44%

21,500

--

 

8.75% Mortgage Note, payable in Monthly Installments
  (Principal and Interest) through 2039

--

 

1,147

 
 


 
   

$103,617

 

$73,863

 
 


 
 

Securities sold under agreements to repurchase are collateralized by mortgage-backed securities. The pledged assets had a carrying value of $51.57 million and a market value of $51.65 million at December 31, 2007. The variable rate repurchase agreement bears interest at three month LIBOR plus .45% and is capped when three month LIBOR reaches 5.25%, and interest cost will be reduced by the cash flows from an embedded floor if three month LIBOR falls below 4%. The fixed rate repurchase agreements have a final maturity of five years and are callable quarterly after two years. The cost of this funding will be reduced by the cash flows of embedded interest rate caps that will come into the money when three month LIBOR reaches rates ranging from 5.07% to 5.62%.

 

The 8.75% Mortgage Note relates to an investment in an affordable housing project made through a previously consolidated limited partnership. The monthly installments are subsidized by the U.S. Department of Agriculture, which pays amounts annually so as to reduce the monthly principal and interest payments to an amount equivalent to a loan at a rate of 1%. The project was sold in December 2007 and the mortgage was assumed by the purchaser.

 

Contractual maturities and amortization of long-term debt subsequent to December 31, 2007, are as follows: 2008 - $48.01 million; 2009 - $26.65 million; 2010 - $5.00 million; 2011 - $47 thousand; 2012 - $21.55 million and $2.36 million thereafter.

 

As of December 31, 2007, Merchants had an estimated additional borrowing capacity with the Federal Home Loan Bank of $129 million and the ability to borrow through the use of repurchase agreements, collateralized by Merchants' investments, with certain approved counterparties.

 

(8) TRUST PREFERRED SECURITIES

 

On December 15, 2004 Merchants closed its private placement of an aggregate of $20 million of trust preferred securities. The placement occurred through a newly formed Delaware statutory trust affiliate of Merchants, MBVT Statutory Trust I (the "Trust"), as part of a pooled trust preferred program. The Trust was formed for the sole purpose of issuing capital securities which are non-voting. Merchants owns all of the common securities of the trust. The proceeds from the sale of the capital securities were loaned to Merchants under deeply subordinated debentures issued to the Trust. The debentures are the only asset of the Trust and payments under the debentures are the sole revenue of the Trust. Merchants' primary source of funds to pay interest on the debentures held by the Trust is current dividends from its principal subsidiary, Merchants Bank. Accordingly, Merchants' ability to service the debentures is dependent upon the continued ability of Merchants Bank to pay dividends to Merchants.

 

These hybrid securities qualify as regulatory capital for Merchants, up to certain regulatory limits. At the same time they are considered debt for tax purposes, and as such, interest payments are fully deductible. The trust preferred securities total $20.62 million, bear interest for five years at a fixed rate of 5.95%, and after five years, the rate adjusts

<PAGE>  59

quarterly at a fixed spread over three month LIBOR. The trust preferred securities mature on December 31, 2034, and are redeemable at Merchants' option, subject to prior approval by the Federal Reserve, beginning after five years from issuance. Merchants incurred $400 thousand in costs to issue the securities, which are being amortized over five years using the straight-line method. The proceeds from the sale of the trust preferred securities were used for general corporate purposes, and helped fund the special dividend declared on December 1, 2004.

 

(9) INCOME TAXES

 

The components of the provision for income taxes were as follows for the years ended December 31, 2007, 2006 and 2005:

 
 

(In thousands)

2007  

 

2006  

 

2005  

 
 


 
 

Current

$4,237 

 

$3,384 

 

$2,387

 
 

Deferred

(976)

 

(83)

 

1,364

 
 


 
 

Provision for Income Taxes

$3,261 

 

$3,301 

 

$3,751

 
 


 
               

Not included in the above table is the income tax impact associated with the unrealized gain or loss on securities available for sale and the income tax impact associated with the funded status of the pension plan, which are recorded directly in shareholders' equity.

 

The tax effects of temporary differences and tax credits that give rise to deferred tax assets and liabilities at December 31, 2007 and 2006 are presented below:

 
 

(In thousands)

2007   

 

2006   

 
 


 
 

Deferred Tax Assets:

       
 

    Allowance for Loan Losses

$ 2,922 

 

$ 2,409 

 
 

    Deferred Compensation

1,572 

 

1,625 

 
 

    Low income housing credit carryforward

-- 

 

501 

 
 

    Core Deposit Intangible

288 

 

354 

 
 

    Other

147 

 

194 

 
 


 
 

            Total Deferred Tax Assets

$ 4,929 

 

$ 5,083 

 
 


 
 

Deferred Tax Liabilities:

       
 

    Depreciation

$   (522)

 

$   (598)

 
 

    Accrued Liabilities

(744)

 

(624)

 
 

    Loan Market Adjustment

(2,437)

 

(2,909)

 
 

    Investments in Real Estate Limited Partnerships

(2,729)

 

(3,431)

 
 


 
 

            Total Deferred Tax Liabilities

$(6,432)

 

$(7,562)

 
 


 
 

            Net Deferred Tax Liability

$(1,503)

 

$(2,479)

 
 


 
           

In addition to the deferred tax assets and liabilities described above, Merchants had a deferred tax asset related to the net unrealized loss on securities available for sale of $38 thousand and $1.98 million at December 31, 2007 and 2006, respectively. Merchants also had a deferred tax asset of $717 thousand and $946 thousand at December 31, 2007 and 2006, respectively, related to the recognition of the funded status of the pension plan.

 

In assessing the realizability of Merchants' total deferred tax assets, management considers whether it is more likely than not that some portion or all of those assets will not be realized. Based upon management's consideration of historical and anticipated future pre-tax income, as well as the reversal period for the items giving rise to the deferred tax assets and liabilities, a valuation allowance for deferred tax assets was not considered necessary at December 31, 2007 and 2006.

<PAGE>  60

The following is a reconciliation of the federal income tax provision, calculated at the statutory rate of 35%, to the recorded provision for income taxes:

 
 

(In thousands)

2007    

 

2006    

 

2005    

 
 


 
 

Applicable Statutory Federal Income Tax

$ 4,942 

 

$ 4,960 

 

$ 5,479 

 
 

(Reduction) Increase in Taxes Resulting From:

           
 

    Tax-exempt Income

(28)

 

(21)

 

(19)

 
 

    Housing Tax Credits

(1,653)

 

(1,650)

 

(1,700)

 
 

    Other, Net

-- 

 

12 

 

(9)

 
 


 
 

Provision for Income Taxes

$ 3,261 

 

$ 3,301 

 

$ 3,751 

 
 


 
     

In June 2006, the Financial Accounting Standards Board ("FASB") issued Interpretation No. 48, "Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109" ("FIN 48"). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements by prescribing a recognition threshold of more-likely-than-not, and a measurement attributable for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return in order for the related tax benefits to be recognized or continue to be recognized. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosures and transitions. FIN 48 is effective for fiscal years beginning after December 15, 2006 and is to be applied to all tax positions upon initial adoption of this standard.

 

On January 1, 2007 Merchants adopted the provisions of FIN 48 and there was no impact to the consolidated financial statements. Upon the adoption of this standard, Merchants performed an analysis of its tax positions to determine whether there may be uncertainties that require further analysis under FIN 48 based upon their specific facts and circumstances. Merchants did not identify at adoption any tax positions that contained significant uncertainties.

 

Merchants is currently open to audit under the statute of limitations by the Internal Revenue Service for the years ending December 31, 2004 through 2007. Merchants' state income tax returns are also open to audit under the statute of limitations for the years ending December 31, 2004 through 2007. Merchants' 2004 federal income tax return was audited by the IRS with insignificant adjustments made to the return as filed.

 

The State of Vermont assesses a franchise tax for banks in lieu of income tax. The franchise tax is assessed based on deposits and amounted to approximately $940 thousand, $893 thousand and $907 thousand in 2007, 2006 and 2005, respectively, which is included as non-interest expense in the accompanying consolidated statement of income.

 

(10) EMPLOYEE BENEFIT PLANS

 

Pension Plan

Prior to January 1995 Merchants maintained a noncontributory defined benefit plan covering all eligible employees. Merchants' Pension Plan (the "Plan") was a final average pay plan with benefits based on the average salary rates over the five consecutive plan years out of the last ten consecutive plan years that produce the highest average. It was Merchants' policy to fund the cost of benefits expected to accrue during the year plus amortization of any unfunded accrued liability that had accumulated prior to the valuation date based on IRS regulations for funding. During 1995 the Plan was curtailed. Accordingly, all accrued benefits were fully vested and no additional years of service or age will be accrued.

 

As discussed in Note 1, Merchants adopted SFAS No. 158 effective December 31, 2006. SFAS No. 158 requires an employer to: (1) recognize the overfunded or underfunded status of a defined benefit postretirement plan, which is measured as the difference between plan assets at fair value and the benefit obligation, as an asset or liability in its balance sheet; (2) recognize changes in that funded status in the year in which the changes occur through comprehensive income; and (3) measure the defined benefit plan assets and obligations as of the date of its year-end balance sheet. SFAS No. 158 does not change how an employer measures plan assets and benefit obligations as of the date of its balance sheet or how it determines the amount of net periodic benefit cost.

<PAGE>  61

During 2006, prior to the adoption of SFAS No. 158, Merchants recorded a minimum pension liability adjustment, after tax, of $246 thousand as a component of other comprehensive income. At December 31, 2006, the underfunded status of $923 thousand was recorded on the consolidated balance sheet, therefore there was no impact on the consolidated balance sheet at December 31, 2006 from the adoption of SFAS No. 158.

 

The Plan's obligations and funded status as of December 31, 2007 and 2006 measurement dates were as follows:

 

 

(In thousands)

2007    

 

2006    

 
 


 
 

Change in Benefit Obligation

       
 

Benefit Obligation at Beginning of Year

$8,058 

 

$8,062 

 
 

Service Costs

43 

 

60 

 
 

Interest Cost

460 

 

396 

 
 

Actuarial (Gain) Loss

(508)

 

107 

 
 

Benefits Paid

(584)

 

(567)

 
 


 
 

Benefit Obligation at Year-end

$7,469 

 

$8,058 

 
 


 
 

Change in Plan Assets

       
 

Fair Value of Plan Assets at Beginning of Year

$7,135 

 

$7,016 

 
 

Actual Return on Plan Assets

509 

 

686 

 
 

Employer Contributions

500 

 

-- 

 
 

Benefits Paid

(598)

 

(567)

 
 


 
 

Fair Value of Plan Assets at Year-end

$7,546 

 

$7,135 

 
 


 
 

Funded Status

$     77 

 

$   (923)

 
 


 
     

The overfunded pension benefits of $77 thousand at December 31, 2007 are included in other assets in Merchants' consolidated balance sheet. On a pre-tax basis, the component of accumulated other comprehensive loss related to the pension plan was the unrecognized net actuarial loss of $2.05 million. Merchants expects that $134 thousand in net actuarial loss will be recognized as a component of net periodic cost in 2008.

 

The underfunded pension benefits of $923 thousand at December 31, 2006 are included in other liabilities in Merchants' consolidated balance sheet. On a pre-tax basis, the component of accumulated other comprehensive loss related to the pension plan was the unrecognized net actuarial loss of $2.70 million

 

The accumulated benefit obligation is equal to the projected benefit obligation at December 31, 2007 and 2006.

 

The following tables summarize the components of net periodic benefit cost and other changes in plan assets and benefit obligations recognized in other comprehensive income for the years ended December 31, 2007, 2006, and 2005, respectively.

 
 

(In thousands)

2007    

 

2006    

 

2005    

 
 


 
 

Interest Cost

$ 461 

 

$ 456 

 

$ 448 

 
 

Expected Return on Plan Assets

(529)

 

(509)

 

(559)

 
 

Service Costs

43 

 

60 

 

-- 

 
 

Net Loss Amortization

181 

 

249 

 

150 

 
 


 
 

Net Periodic Pension Cost

$ 156 

 

$ 256 

 

$   39 

 
 


 
     

 

(In thousands)

2007    

 

2006    

 

2005    

 
 


 
 

Net Gain

$(474)

 

-- 

 

-- 

 
 

Net Loss amortization

(181)

 

-- 

 

-- 

 
 


 
 

Total recognized in Other Comprehensive Income

$(655)

 

-- 

 

-- 

 
 


 
 

Total recognized in net periodic pension cost and
  Other Comprehensive Income

$(499)

 

$ 256 

 

$   39 

 
 


 

<PAGE>  62

The following table summarizes the assumptions used to determine the benefit obligations at December 31, 2007, 2006 and 2005, and net periodic benefit costs for the years ended December 31, 2007, 2006 and 2005:

 

 

(In thousands)

2007    

 

2006    

 

2005    

 
 


 
 

Benefit Obligations

           
 

    Discount Rate

6.40%

 

5.84%

 

5.65%

 
 

    Expected Long-term Return on Plan Assets

7.50%

 

7.50%

 

7.50%

 
 

Net Periodic Benefit Cost

           
 

    Discount Rate

5.84%

 

5.65%

 

5.75%

 
 

    Expected Long-term Return on Plan Assets

7.50%

 

7.50%

 

7.50%

 
 


 
     

The discount rate reflects the rates at which pension benefits could be effectively settled. Merchants looks to rates of return on high-quality fixed income investments currently available and expected to be available during the period of maturity of the pension benefits. Consideration was given to the rates that would be used to settle plan obligations as of December 31, 2007 and to the rates of other indices at year-end. Merchants' actuary used a bond matching model using individual bond yield data which matched the spot rate to the expected future benefit payments of the plan over a 99 year period. The expected long-term rate of return on plan assets reflects long-term earnings expectations on existing plan assets and those contributions expected to be received during the current plan year. In estimating that rate, appropriate consideration was given to historical returns earned by plan assets in the fund and the rates of return expected to be available for reinvestment. Rates of return were adjusted to reflect current capital market assumptions and changes in investment allocations, if any.

 

The following table sets forth the target asset allocation, and the asset allocation percentages as of December 31, 2007 and 2006, for Merchants' Pension Plan:

 

Target
Allocation

Allocation
Percentage
12/31/2007

Allocation
Percentage
12/31/2006

 


 
 

Equity Securities

60-70%

65%

66%

 
 

Debt Securities

30-40%

33%

26%

 
 

Other/Cash

--

2%

8%

 
 


 
 

Total

 

100%

100%

 
 


 
     

Merchants' Pension Plan Investment Policy Statement sets forth the investment objectives and constraints of the Plan. The purpose of the policy is to assist the Retirement Plan Committee of Merchants in effectively supervising, monitoring and evaluating the investments of the Plan.

 

The investment objectives are to provide both income and capital appreciation and to assist with current and future spending needs of the Plan while at the same time minimizing the risks of investing. The investment target of the Plan is to achieve a total annual rate of return in excess of the change in the Consumer Price Index for the aggregate investments of the Plan evaluated over a period of five years. A certain amount of risk must be assumed to achieve the Plan's investment target rate of return. The Plan diversifies its assets to help to minimize the risks of investing. The Plan also uses a long time horizon to evaluate its returns. The Plan's asset allocation is based on this long-term perspective.

 

Specific guidelines regarding allocation of assets are as follows: equities shall be managed to a target of 65% of total investments and fixed income securities will be managed to a target of 35% of total investments, with a 5% tolerance either below or above, as measured on a quarterly basis. If the exposure for equities is less than 60% or greater than 70%, or the exposure for fixed income is less than 30% or greater than 40% at the end of any quarter, the assets will be rebalanced in order to restore the equity exposure.

 

There are no contributions expected to be made to the Plan in 2008.

<PAGE>  63

The following table summarizes the estimated future benefit payments expected to be paid under the Plan:

 

(In thousands)

Pension
Benefits

 


 
 

2008

$   452

 
 

2009

402

 
 

2010

419

 
 

2011

443

 
 

2012

437

 
 

Years 2013 to 2017

2,595

 
 


 
     

The estimated future benefit payments expected to be paid under the Plan are based on the same assumptions used to measure Merchants' benefit obligation at December 31, 2007. No future service estimates were included due to the frozen status of the Plan.

 

401(k) Employee Stock Ownership Plan

Under the terms of Merchants' 401(k) Employee Stock Ownership Plan ("401(k)") eligible employees are entitled to contribute up to 75% of their compensation to the 401(k), and Merchants contributes a percentage of the amounts contributed by the employees as authorized by Merchants' Board of Directors. Merchants contributed approximately 51%, 107% and 109% of the amounts contributed by the employees in 2007, 2006 and 2005, respectively. Prior to 2007 Merchants contributed 200% of up to 4.5% of individual employee compensation; effective in 2007, the match was reduced to 100% of up to 4.5% of individual employee compensation.

 

Summary of Expense

A summary of expense relating to Merchants' various employee benefit plans for each of the years in the three year period ended December 31, 2007 is as follows:

 
 
 

(In thousands)

2007    

 

2006    

 

2005    

 
 


 
 

Pension Plan

$156

 

$   256

 

$  39

 
 

401(k) Employee Stock Ownership Plan

441

 

878

 

914

 
 


 
 

Total

$597

 

$1,134

 

$953

 
 


 
     

(11) STOCK-BASED COMPENSATION PLANS

 

Stock Option Plan

Merchants has granted stock options to certain key employees. The options are exercisable immediately after the three year vesting period. Nonqualified stock options may be granted at any price determined by the Nominating and Governance Committee of Merchants' Board of Directors. All stock options have been granted at or above fair market value at the date of grant. The stock option plan expired in May 2007. A new plan will be brought to shareholders for their approval in May 2008.

 

Effective January 1, 2006, Merchants adopted the provisions of SFAS No. 123(R), using a modified prospective application. Merchants granted 10,000 options during the third quarter of 2006, the first options granted since August 2001. The fair value of the options granted during 2006 was $4.70 per option. The fair value of each option grant is estimated on the grant date using the Black-Scholes option-pricing model that requires Merchants to develop estimates for assumptions used in the model. The Black-Scholes valuation model uses the following assumptions: expected volatility, expected term of option, risk-free interest rate and dividend yield. Expected volatility estimates are developed by Merchants based on historical volatility of Merchants' stock. Merchants uses historical data to estimate the expected term of the options. The risk-free interest rate for periods within the expected life of the option is based on the U.S. Treasury yield in effect at the grant date. The dividend yield represents the expected dividends on Merchants' stock. No options were granted during 2007.

<PAGE>  64

A summary of Merchants' stock option plan as of December 31, 2007, 2006 and 2005 and changes during the years then ended are as follows, with numbers of shares in thousands:

 
 

2007

2006

2005

Number
Of
Shares

Weighted
Average
Exercise
Price
Per Share

Number
Of
Shares

Weighted
Average
Exercise
Price
Per Share

Number
Of
Shares

Weighted
Average
Exercise
Price
Per Share


Options Outstanding, Beginning of Year

166

$19.09

204

$17.96

280

$17.78

Granted

  --

       --

  10

  26.63

  --

       --

Exercised

  30

  18.50

  48

  15.88

  76

  16.49

Expired

    7

  18.50

  --

       --

  --

       --


Options Outstanding, End of Year

129

$19.25

166

$19.09

204

$17.96


Options Exercisable

119

$18.63

156

$18.60

204

$17.96


 

As of December 31, 2007, there were options outstanding within the following ranges: 69 thousand at prices within the range of $15.50 to $20.00, 50 thousand at prices within the range of $20.01 to $23.00, and 10 thousand at $26.63.

 

The total intrinsic value of options exercised was $131 thousand, $383 thousand and $772 thousand for the three years ended December 31, 2007, 2006 and 2005, respectively. Merchants generally uses shares held in treasury for option exercises. Options outstanding at December 31, 2007 had an aggregate intrinsic value of $550 thousand and a weighted average remaining contractual term of 1.99 years. Options exercisable at December 31, 2007 had an aggregate intrinsic value of $582 thousand and a weighted average remaining contractual term of 1.34 years. The total cash received from employees, net of withholding taxes, as a result of employee stock option exercises was $155 thousand, $231 thousand and $75 thousand for the years ended December 31, 2007, 2006 and 2005, respectively. Total shares surrendered by employees to satisfy the exercise price in conjunction with option exercises were 16,976 shares, 22,522 shares and 44,670 shares for the years ended December 31, 2007, 2006 and 2005, respectively. The tax benefit realized as a result of the stock option exercises was $15 thousand, $120 thousand and $270 thousand for the years ended December 31, 2007, 2006 and 2005, respectively.

 

The total compensation cost recognized related to options was $16 thousand for 2007 and $10 thousand for 2006. Compensation cost related to options is included in salary expense in the accompanying consolidated Statements of Income. Compensation expense for options granted is recognized on a straight line basis over the vesting period.

 

Deferred Compensation Plans

In December 1995 Merchants established several plans (the "Plans") and trusts with Merchants Trust Company, to which it contributed an amount sufficient to cover Merchants' obligations to directors. The Plans used those payments, in part, to purchase newly issued common stock of Merchants at its then market price. The purchases have been accounted for as treasury stock transactions in Merchants' consolidated financial statements and are included in shares outstanding for purposes of computing earnings per share.

 

In May 1997 Merchants established a deferred compensation plan for non-employee directors. The plan expired in May 2007; a new plan will be brought to shareholders for their approval in May 2008. Under the terms of these plans participating directors could elect to have all, or a specified percentage, of their director's fees for a given year paid in the form of cash or deferred in the form of restricted shares of Merchants' common stock. Directors who elect to have their compensation deferred are credited with a number of shares of Merchants' common stock equal in value to the amount of fees deferred plus a risk premium of not more than 25% of the amount deferred. The risk premium level has been set at 20% since the inception of the plan. The participating director may not sell, transfer or otherwise dispose of these shares prior to distribution. With respect to shares of common stock issued or otherwise transferred to a participating director, the participating director will have the right to receive dividends or other distributions thereon. If a participating director resigns under certain circumstances, the director forfeits all of his or her shares which are risk premium shares. The total amount of unearned compensation cost related to non-vested risk premium shares was $56 thousand at December 31, 2007. During 2007, 912 risk premium shares were granted. The grant date fair value of the risk premium shares is recognized as an expense ratably over the five-year vesting period.

<PAGE>  65

(12) EARNINGS PER SHARE

 

The following table presents reconciliations of the calculations of basic and diluted earnings per share for the years ended December 31, 2007, 2006 and 2005:

 
   

2007    

 

2006    

 

2005    

 
 


 
   

(In thousands except share and per share data)

 
 

Net Income

$10,858

 

$10,871

 

$11,902

 
 

Weighted Average Common Shares Outstanding

6,148

 

6,276

 

6,319

 
 

Dilutive Effect of Common Stock Equivalents

16

 

24

 

42

 
 

Weighted Average Common and Common

           
 

  Equivalent Shares Outstanding

6,164

 

6,300

 

6,361

 
 

Basic Earnings Per Share

$    1.77

 

$    1.73

 

$    1.88

 
 

Diluted Earnings Per Share

$    1.76

 

$    1.73

 

$    1.87

 
 


 
     

Basic earnings per common share were computed by dividing net income by the weighted average number of shares of common stock outstanding during the year. The computation of diluted earnings per share excludes the effect of assuming the exercise of certain outstanding stock options because the effect would be anti-dilutive. The average anti-dilutive options outstanding for 2007, 2006 and 2005 were 10,000, 3,753, and zero respectively.

 

(13) PARENT COMPANY

 

The Parent Company's investments in its subsidiaries are recorded using the equity method of accounting. Summarized financial information relative to the Parent Company only balance sheets at December 31, 2007 and 2006, and statements of income and cash flows for each of the years in the three year period ended December 31, 2007, are shown in the following table. The statement of changes in stockholders' equity for the Parent Company are not reported because they are identical.

 

Balance Sheets as of December 31,

 

(In thousands)

 

2007      

 

2006      


Assets:

       

    Investment in and Advances to Subsidiaries*

 

$95,099

 

$89,536

    Cash*

 

760

 

828

    Other Assets

 

293

 

398


            Total Assets

 

$96,152

 

$90,762


Liabilities and Shareholders' Equity:

       

    Other Liabilities

 

$     226

 

$     446

    Long Term Debt

 

20,619

 

20,619

    Shareholders' Equity

 

75,307

 

69,697


            Total Liabilities and Shareholders' Equity

 

$96,152

 

$90,762


 

Statements of Income for the Years Ended December 31,

 

(In thousands)

 

2007      

 

2006      

 

2005      


Dividends from Merchants Bank*

 

$10,550 

 

$  8,786 

 

$  6,831 

Equity in Undistributed (Distributed) Earnings of Subsidiaries

 

1,507 

 

3,198 

 

6,047 

Other Expense, Net

 

(1,705)

 

(1,712)

 

(1,495)

Benefit from Income Taxes

 

506 

 

599 

 

519 


            Net Income

 

$10,858 

 

$10,871 

 

$11,902 


<PAGE>  66

Statements of Cash Flows for the Years Ended December 31,

 

(In thousands)

 

2007      

 

2006      

 

2005      


Cash Flows from Operating Activities:

           

    Net Income

 

$10,858 

 

$10,871 

 

$11,902 

    Adjustments to Reconcile Net Income to Net Cash Provided by
      Operating Activities:

           

        Decrease (Increase) in Other Assets

 

105 

 

835 

 

724 

        Increase in Other Liabilities

 

(220)

 

284 

 

99 

        Tax Benefit from Exercises of Stock Options

 

-- 

 

-- 

 

270 

        Equity in (Undistributed) Distributed Earnings of Subsidiaries

 

(1,507)

 

(3,198)

 

(6,047)


Net Cash Provided by Operating Activities

 

9,236 

 

8,792 

 

6,948 


Cash Flows from Financing Activities:

           

    Purchases of Treasury Stock

 

(3,483)

 

(3,993)

 

(4,474)

    Sale of Treasury Stock

 

12 

 

11 

 

3,567 

    Proceeds from Exercise of Stock Options

 

155 

 

231 

 

75 

    Tax Benefit from Exercises of Stock Options

 

15 

 

120 

 

-- 

    Cash Dividends Paid

 

(6,138)

 

(6,203)

 

(6,039)

    Other, Net

 

135 

 

260 

 

243 


Net Cash Used in Financing Activities

 

(9,304)

 

(9,574)

 

(6,628)


(Decrease) Increase in Cash and Cash Equivalents

 

(68)

 

(782)

 

320 

Cash and Cash Equivalents at Beginning of Year

 

828 

 

1,610 

 

1,290 


Cash and Cash Equivalents at End of Year

 

$     760 

 

$     828 

 

$  1,610 


 

* Account balances are partially or fully eliminated in consolidation.

 

(14) COMMITMENTS AND CONTINGENCIES

 

Financial Instruments with Off-Balance Sheet Risk

Merchants is a party to financial instruments with offbalance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments primarily include commitments to extend credit and financial guarantees. Such instruments involve, to varying degrees, elements of credit and interest rate risk that are not recognized in the accompanying consolidated balance sheets.

 

Exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and financial guarantees written is represented by the contractual amount of those instruments. Merchants uses the same credit policies in making commitments as it does for on balance sheet instruments. The contractual amounts of these financial instruments at December 31, 2007 and 2006 are as follows:

 
           
 

(In thousands)

2007

 

2006

 
 


 
 

Financial Instruments Whose Contract Amounts

       
 

  Represent Credit Risk:

       
 

    Commitments to Originate Loans

$  10,603

 

$  23,660

 
 

    Unused Lines of Credit

131,085

 

130,245

 
 

    Standby Letters of Credit

5,221

 

6,147

 
 

    Loans Sold with Recourse

403

 

589

 
 

Equity Commitments to Affordable Housing

       
 

  Limited Partnerships

1,479

 

14

 
 


 
           

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. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since a portion of the commitment is expected to expire without being drawn upon, the total

<PAGE>  67

commitment amount does not necessarily represent a future cash requirement. Merchants evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained by Merchants upon extension of credit is based on management's credit evaluation of the counterparty, and an appropriate amount of real and/or personal property is obtained as collateral.

 

FASB Interpretation No. 45 ("FIN No. 45"), "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others; an Interpretation of FASB Statements No. 5, 57, and 107 and rescission of FASB Interpretation No. 34", requires certain disclosures and liability-recognition for the fair value at issuance of guarantees that fall within its scope. Under FIN No. 45, Merchants does not issue any guarantees that would require liability-recognition or disclosure, other than its standby letters of credit. Merchants has issued conditional commitments in the form of standby letters of credit to guarantee payment on behalf of a customer and guarantee the performance of a customer to a third party. Standby letters of credit generally arise in connection with lending relationships. The credit risk involved in issuing these instruments is essentially the same as that involved in extending loans to customers. Contingent obligations under standby letters of credit totaled approximately $5.22 million and $6.15 million at December 31, 2007 and 2006, respectively, and represent the maximum potential future payments Merchants could be required to make. Typically, these instruments have terms of 12 months or less and expire unused; therefore, the total amounts do not necessarily represent future cash requirements. Each customer is evaluated individually for creditworthiness under the same underwriting standards used for commitments to extend credit and on-balance sheet instruments. Merchants' policies governing loan collateral apply to standby letters of credit at the time of credit extension. Loan-to-value ratios are generally consistent with loan-to-value requirements for other commercial loans secured by similar types of collateral.

 

Merchants may enter into commitments to sell loans, which involve market and interest rate risk. There were no such commitments at December 31, 2007 or 2006.

 

Interest Rate Cap and Floor Contracts

Interest rate caps allow the purchaser to "cap" the contractual rate associated with a liability; alternatively interest rate floors allow the purchaser to protect the rate of return on an asset. Merchants may use floor contracts to mitigate the effects on net interest income in the event interest rates on floating rate loans decline and may use cap contracts to mitigate the effects on net interest income should interest rates on floating rate deposits increase. As of December 31, 2007 Merchants had a $30 million interest rate cap outstanding. The cap was purchased in January 2007 and matures in January 2009, and is struck on three month LIBOR, the strike rate is 5.50%. The fair value of the cap at December 31, 2007 was insignificant.

 

Balances at the Federal Reserve Bank

At December 31, 2007 and 2006, amounts at the Federal Reserve Bank included $1.16 million and $3.7 million, respectively, held to satisfy certain reserve requirements of the Federal Reserve Bank.

 

Legal Proceedings

Merchants and certain of its subsidiaries have been named as defendants in various legal proceedings arising from their normal business activities. Although the amount of any ultimate liability with respect to such proceedings cannot be determined, in the opinion of management, based upon the opinion of counsel on the outcome of such proceedings, any such liability will not have a material effect on the consolidated financial position of Merchants and its subsidiaries.

 

(15) FAIR VALUE OF FINANCIAL INSTRUMENTS

 

Investments

The carrying amounts reported in the consolidated balance sheets for cash and cash equivalents and the Federal Home Loan Bank stock approximate fair value. Fair value for investment securities is determined from quoted market prices, when available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments.

<PAGE>  68

An analysis of the fair value of the investment securities as of December 31, 2007 and 2006 is as follows:

 
   

2007

2006

 

(In thousands)

Carrying
Amount

Fair
Value

Carrying
Amount

Fair
Value

 


 
 

Securities Available for Sale

$361,512

$361,512

$333,958

$333,958

 
 

Securities Held to Maturity

4,078

4,283

5,615

5,804

 
 


 
   

$365,590

$365,795

$339,573

$339,762

 
 


 
     

Loans

The fair value of variable rate loans that reprice frequently and have no significant credit risk is based on carrying values. The fair value for other loans is estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality.

 

An analysis of the fair value of the loan portfolio as of December 31, 2007 and 2006 is as follows:

 
   

2007

2006

 

(In thousands)

Carrying
Amount

Fair Value

Carrying
Amount

Fair Value

 


 
 

Gross Loans

$731,508

$732,548

$689,283

$687,886

 
 

Allowance for Loan Losses

8,002

--

6,911

--

 
 


 
 

Net Loans

$723,506

$732,548

$682,372

$687,866

 
 


 
     

Deposits

The fair value of demand deposits approximates the amount reported in the consolidated balance sheets. The fair value of variable rate, fixed term certificates of deposit also approximates the carrying amount reported in the consolidated balance sheets. The fair value of fixed rate and fixed term certificates of deposit is estimated using a discounted cash flow which applies interest rates currently being offered for deposits of similar remaining maturities.

 

An analysis of the fair value of deposits as of December 31, 2007 and 2006 is as follows:

 
   

2007

2006

 

(In thousands)

Carrying
Amount

Fair
Value

Carrying
Amount

Fair
Value

 


 
 

Demand Deposits

$123,344

$123,344

$122,036

$122,036

 
 

Savings, NOW and Money Market

411,321

411,321

442,442

442,442

 
 

Time Deposits $100 thousand and greater

85,738

85,657

76,822

76,169

 
 

Other Time Deposits

247,034

246,807

236,052

234,046

 
 


 
   

$867,437

$867,129

$877,352

$874,693

 
 


 
             

Debt

The fair value of debt is estimated using current market rates for borrowings of similar remaining maturity. An analysis of the fair value of the borrowings of Merchants as of December 31, 2007 and 2006 is as follows:

 
   

2007

2006

 

(In thousands)

Carrying
Amount

Fair
Value

Carrying
Amount

Fair
Value

 


 
 

Short-term Borrowings

$  2,167

$  2,167

$  4,000

$  4,000

 
 

Long-term Debt

62,117

62,528

53,863

53,504

 
 

Securities Sold Under Agreement to

         
 

  Repurchase-Short Term

96,750

96,565

86,547

86,387

 
 

Securities Sold Under Agreement to

         
 

  Repurchase-Long Term

41,500

40,724

20,000

20,186

 
 

Junior Subordinated Debentures issued

         
 

  to Unconsolidated Subsidiary Trust

20,619

17,655

20,619

22,420

 
 


 

<PAGE>  69

Commitments to Extend Credit and Standby Letters of Credit

The fair value of commitments to extend credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of financial standby letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties. The fair value of commitments to extend credit and standby letters of credit is approximately $52 thousand and $61 thousand as of December 31, 2007 and 2006, respectively.

 

(16) REGULATORY CAPITAL REQUIREMENTS

 

Merchants is subject to various regulatory capital requirements administered by federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on Merchants' financial statements. Under capital adequacy guidelines, Merchants must meet specific capital guidelines that involve quantitative measures of its assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. It is the policy of the Federal Reserve Board that banks and bank holding companies, respectively, should pay dividends only out of current earnings and only if, after paying such dividends, the bank or bank holding company would remain adequately capitalized. Merchants is also subject to the regulatory framework for prompt corrective action that requires it to meet specific capital guidelines to be considered well capitalized. Merchants' capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

 

Quantitative measures established by regulation to ensure capital adequacy require Merchants to maintain minimum ratios (set forth in the table below) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined) and of Tier 1 capital (as defined) to average assets (as defined). Management believes, as of December 31, 2007, that Merchants met all capital adequacy requirements to which it is subject.

 

As of December 31, 2007, the most recent notification from the FDIC categorized Merchants Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed Merchants Bank's category. To be considered well capitalized under the regulatory framework for prompt corrective action, Merchants Bank must maintain minimum Tier 1 Leverage, Tier 1 Risk-Based, and Total Risk-Based Capital ratios. Set forth in the table below are those ratios as well as those for Merchants Bancshares, Inc.

 

Actual

For Capital
Adequacy Purposes

To Be Well-
Capitalized Under
Prompt Corrective
Action Provisions

 

(In thousands)

Amount(1)

Percent

Amount

Percent

Amount

Percent

 
 


 
 

As of December 31, 2007

             
 

Merchants Bancshares, Inc.:

             
 

    Tier 1 Leverage Capital

$  95,258

8.14%

$46,787

4.00%

N/A

   
 

    Tier 1 Risk-Based Capital

95,258

12.75%

29,896

4.00%

N/A

   
 

    Total Risk-Based Capital

103,608

13.86%

59,793

8.00%

N/A

   
 

Merchants Bank:

             
 

    Tier 1 Leverage Capital

$  94,431

8.05%

$46,947

4.00%

$58,684

5.00%

 
 

    Tier 1 Risk-Based Capital

94,431

12.55%

30,102

4.00%

45,152

6.00%

 
 

    Total Risk-Based Capital

102,781

13.66%

60,203

8.00%

75,254

10.00%

 
 


 
 

As of December 31, 2006

             
 

Merchants Bancshares, Inc.:

             
 

    Tier 1 Leverage Capital

$  93,121

8.24%

$45,204

4.00%

N/A

   
 

    Tier 1 Risk-Based Capital

93,121

12.59%

29,580

4.00%

N/A

   
 

    Total Risk-Based Capital

100,403

13.58%

59,159

8.00%

N/A

   
 

Merchants Bank:

             
 

    Tier 1 Leverage Capital

$  92,571

8.16%

$45,355

4.00%

$56,693

5.00%

 
 

    Tier 1 Risk-Based Capital

92,571

12.45%

29,737

4.00%

44,605

6.00%

 
 

    Total Risk-Based Capital

99,853

13.43%

59,474

8.00%

74,342

10.00%

 
 


 
     

(1)

Capital amounts for Merchants Bancshares, Inc. include $20 million in trust preferred securities issued in December 2004. These hybrid securities qualify as regulatory capital up to certain regulatory limits.

   

<PAGE>  70

Accumulated Other Comprehensive Loss at December 31, 2007 consisted of a net unrecognized actuarial loss on the company's defined benefit plan in the amount of $1.33 million and the unrealized loss on securities available for sale of $90 thousand, both net of taxes.

 

(17) CUMULATIVE ADJUSTMENT TO RETAINED EARNINGS UNDER SEC STAFF ACCOUNTING

         BULLETIN NO. 108

 

In September 2006, the staff of the SEC issued Staff Accounting Bulletin ("SAB") No. 108 which was issued in order to eliminate the diversity of practice surrounding how public companies quantify financial statement misstatements. There are two widely recognized methods for quantifying the effects of financial statement misstatements: the "roll-over" and "iron curtain" methods. The roll-over method focuses primarily on the impact of a misstatement on the income statement. The iron curtain method quantifies misstatements based on the effects of correcting misstatements that exist in the balance sheet at the end of the current year, regardless of the misstatement's year(s) of origin. In SAB 108, the SEC staff established an approach that requires quantification of financial statement misstatements based on the effects of the misstatements under both the roll-over and iron curtain methods. This framework is referred to as the "dual approach." SAB 108 permits companies to initially apply its provisions either by restating prior financial statements as if the dual approach had always been used or recording the cumulative effect of initially applying the dual approach as adjustments to the balance sheet as of the first day of the fiscal year with an offsetting adjustment recorded to retained earnings. Prior to SAB No. 108, Merchants utilized the roll-over approach when quantifying misstatements. The provisions of SAB No. 108 must be applied to financial statements for fiscal years ending after November 15, 2006.

 

As a result of the adoption of SAB No. 108, Merchants recognized a reduction in other liabilities and an increase in other assets, as described below. These entries were recorded as adjustments of the beginning of the year 2006 opening balances for these accounts and the impact was reflected in shareholders' equity as a cumulative effect adjustment to retained earnings. The entry to reduce other liabilities was in connection with a $620 thousand over accrual of income tax expense which occurred over several years prior to 2004. The entry to increase other assets was in connection with an inappropriate recognition of $190 thousand related to an adjustment to another asset prior to 1997.

 

Merchants' management has concluded that these adjustments are immaterial to prior years' consolidated financial statements under its previous method of assessing materiality, and therefore has elected, as permitted under the transition provisions of SAB No. 108, to reflect the effect of these adjustments in opening assets and liabilities as of January 1, 2006, with the offsetting adjustment reflected as a cumulative effect adjustment to opening retained earnings as of January 1, 2006.

<PAGE>  71

Report of Independent Registered Public Accounting Firm

 

The Board of Directors and Shareholders

of Merchants Bancshares, Inc.:

 

We have audited the accompanying consolidated balance sheets of Merchants Bancshares, Inc. and subsidiaries (the "Company") as of December 31, 2007 and 2006, and the related consolidated statements of income, changes in shareholders' equity, comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2007. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated 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 Merchants Bancshares, Inc. and subsidiaries as of December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2007 in conformity with U.S. generally accepted accounting principles.

 

As discussed in note 17 to the consolidated financial statements, the Company changed its method of quantifying errors in 2006.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company's internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated March 12, 2008 expressed an unqualified opinion on the effectiveness of the Company's internal control over financial reporting.

 

/s/ KPMG LLP

 

Albany, New York

March 12, 2008

<PAGE>  72

Report of Independent Registered Public Accounting Firm

 

The Board of Directors and Shareholders

of Merchants Bancshares, Inc.:

 

We have audited Merchants Bancshares, Inc. and subsidiaries' (the "Company"), internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission ("COSO"). The Company'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, included in the accompanying Management Report. Our responsibility is to express an opinion on 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, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of control based on the assessed risk. Our audit also included 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 a 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, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control - Integrated Framework issued by COSO.

 

We also have audited in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Merchants Bancshares, Inc. and subsidiaries as of December 31, 2007 and 2006, and the related consolidated statements of income, changes in shareholders' equity, comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2007, and our report dated March 12, 2008 expressed an unqualified opinion on those consolidated financial statements.

 

/s/ KPMG LLP

 

Albany, New York

March 12, 2008

<PAGE>  73

ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND

                  FINANCIAL DISCLOSURES

 

None.

 

ITEM 9A - CONTROLS AND PROCEDURES

 

Evaluation of Disclosure Controls and Procedures - The principal executive officer and principal financial officer of Merchants have evaluated its disclosure controls and procedures (as defined in Rules 13a-15(e) or 15d-15(e) under the Exchange Act) as of December 31, 2007. Based on this evaluation, the principal executive officer and principal financial officer have concluded that Merchants' disclosure controls and procedures effectively ensure that information required to be disclosed in Merchants' filings and submissions with the Securities and Exchange Commission under the Exchange Act is recorded, processed, summarized and reported within the time periods specified by the Securities and Exchange Commission. In addition, Merchants has reviewed its internal control over financial reporting and there have been no changes in its internal control over financial reporting or in other factors during Merchants' most recent fiscal quarter that have materially affected or are likely to materially affect Merchants' internal control over financial reporting.

 

Management's Report on Internal Control Over Financial Reporting - Management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rule 13a-15(f) or 15d-15(f). Merchants' internal control system was designed to provide reasonable assurances to Merchants' management and board of directors regarding the preparation and fair presentation of published financial statements. Under the supervision and with the participation of Merchants' management, including its principal executive officer and principal financial officer, an evaluation of the effectiveness of its internal control over financial reporting was conducted, based on the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on the evaluation under the framework in Internal Control - Integrated Framework, management concluded that its internal control over financial reporting was effective as of December 31, 2007. Merchants internal control over financial reporting as of December 31, 2007 has been audited by KPMG LLP, an independent registered public accounting firm, as stated in their report, which is included in Item 8 herein.

 

ITEM 9B - OTHER INFORMATION - All information required to be disclosed on Form 8-K during the fourth quarter of 2007 has been reported.

 

PART III

 

ITEM 10 - DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

 

ITEM 11 - EXECUTIVE COMPENSATION

 

ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND

                   RELATED STOCKHOLDER MATTERS

 

ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR

                   INDEPENDENCE

 

ITEM 14 - PRINCIPAL ACCOUNTANT FEES AND SERVICES

 

Reference is hereby made to Merchants' Proxy Statement to Shareholders for its Annual Meeting of Shareholders to be held on May 6, 2008, wherein pursuant to Regulation 14A information concerning the above subjects (Items 10 through 14) is incorporated by reference.

 

Pursuant to Rule 12b-23 and Instruction G to Form 10-K, definitive copies of the Proxy Statement will be filed within 120 days subsequent to the end of Merchants' 2007 fiscal year.

<PAGE>  74

PART IV

 

ITEM 15 - EXHIBITS AND FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

 

(1)

The following consolidated financial statements are included:

   
 

Consolidated Balance Sheets, December 31, 2007, and December 31, 2006

   
 

Consolidated Statements of Income for years ended December 31, 2007, 2006 and 2005

   
 

Consolidated Statements of Comprehensive Income for the years ended December 31, 2007, 2006 and 2005

   
 

Consolidated Statements of Changes in Shareholders' Equity for years ended December 31, 2007, 2006 and 2005

   
 

Consolidated Statements of Cash Flows for the years ended December 31, 2007, 2006 and 2005

   
 

Notes to Consolidated Financial Statements

   

(2)

The following exhibits are either filed or attached as part of this report, or are incorporated herein by reference:

   

Exhibit

 

Description

 

  3.1.1

 

Certificate of Incorporation, filed April 20, 1987 (Incorporated by reference to Exhibit B to Pre-Effective Amendment No. 1 to Merchants' Definitive Proxy Statement for the Annual Meeting of the Shareholders of the Company, filed on April 25, 1987)

     

  3.1.2

 

Certificate of Merger, filed June 5, 1987 (Incorporated by reference to Exhibit 3.1.2 to Merchants' Annual Report on Form 10-K for the Year Ended December 31, 2006)

     

  3.1.3

 

Certificate of Amendment, filed May 11, 1988 (Incorporated by reference to Exhibit 3.1.3 to Merchants' Annual Report on Form 10-K for the Year Ended December 31, 2006)

     

  3.1.4

 

Certificate of Amendment, filed April 29, 1991 (Incorporated by reference to Exhibit 3.1.4 to Merchants' Annual Report on Form 10-K for the Year Ended December 31, 2006)

     

  3.1.5

 

Certificate of Amendment, filed August 29, 2006 (Incorporated by reference to Exhibit 3.1.5 to Merchants' Annual Report on Form 10-K for the Year Ended December 31, 2006)

     

  3.1.6

 

Certificate of Amendment, filed August 29, 2006 (Incorporated by reference to Exhibit 3.1.6 to Merchants' Annual Report on Form 10-K for the Year Ended December 31, 2006)

     

  3.2

 

Amended Bylaws of Merchants (Incorporated by reference to Exhibit C to Merchants' Definitive Proxy Statement for the Annual Meeting of the Stockholders of the Company, filed on April 25, 1987)

     

  4

 

Instruments defining the rights of security holders, including indentures:

     

  4.1

 

Specimen of Merchants' Common Stock Certificate

     

  4.2

 

Description of the Rights of Holders of Merchants' Common Stock (appearing on pages 10 through 16 of Merchants' definitive Proxy Statement on Schedule 14A, effective as of April 25, 1987 for Merchants' Annual Meeting of Shareholders held June 2, 1987)

     

10.1

 

Merchants Bancshares, Inc. Dividend Reinvestment and Stock Purchase Plan (Incorporated by reference to Exhibit 4.1 to Merchants' Registration Statement on Form S-3 (Registration No. 333-20375) filed on January 22, 1997)

     

10.2

 

401(k) Employee Stock Ownership Plan of Merchants, dated January 1, 1990, as amended (Incorporated by reference to Merchants' Registration Statement on Form S-8 (Registration Number 33-3274) filed on November 16, 1989)

<PAGE>  75

10.3

 

Amended and Restated Merchants Bank Pension Plan dated as of January 1, 1994 (Incorporated by Reference to Exhibit 10.6 to Post-Effective Amendment Number 1 to Merchants' Registration Statement on Form S-8 (Registration Number 333-18845) filed on December 26, 1996)

     

10.4

 

Form of Employment Agreement dated as of January 1, 2007, by and between Merchants and its subsidiaries and certain of its executive officers (Incorporated by reference to Exhibit 10.4 to Merchants' Annual Report on Form 10-K for the Year Ended December 31, 2006)

     

10.5

 

Fixed/Floating Rate Junior Subordinated Deferrable Interest Debentures dated December 15, 2004;
Merchants Bancshares, Inc. as Issuer, Wilmington Trust Company as Trustee (Incorporated by reference to Exhibit 10.5 to Merchants' Annual Report on Form 10-K for the Year Ended December 31, 2004)

     

10.5.1

 

MBVT Statutory Trust I Subscription Agreement dated December 15, 2004 (Incorporated by reference to Exhibit 10.5.1 to Merchants' Annual Report on Form 10-K for the Year Ended December 31, 2004)

     

10.5.2

 

Declaration of Trust dated December 15, 2004 between Merchants Bancshares, Inc. and Wilmington Trust Company (Incorporated by reference to Exhibit 10.5.2 to Merchants' Annual Report on Form 10-K for the Year Ended December 31, 2004)

     

10.5.3

 

Guarantee Agreement between Merchants Bancshares, Inc. and Wilmington Trust Company dated
December 15, 2004 (Incorporated by reference to Exhibit 10.5.3 to Merchants' Annual Report on Form 10-K for the Year Ended December 31, 2004)

     

10.5.4

 

Placement Agreement dated December 7, 2004 between Merchants Bancshares, Inc. and FTN Financial Capital Markets (Incorporated by reference to Exhibit 10.5.4 to Merchants' Annual Report on Form 10-K for the Year Ended December 31, 2004)

     

10.14

 

The Merchants Bank Amended and Restated Deferred Compensation Plan for Directors (Incorporated by reference to Exhibit 10.14 to Merchants' Annual Report on Form 10-K for the Year Ended December 31, 1997)

     

10.14.1

 

Trust under the Merchants Bank Amended and Restated Deferred Compensation Plan for Directors
(Incorporated by reference to Exhibit 10.14.1 to Merchants' Annual Report on Form 10-K for the Year Ended December 31, 1997)

     

10.14.2

 

The Merchants Bancshares, Inc. Amended and Restated Deferred Compensation Plan for Directors
(Incorporated by reference to Exhibit 10.14.2 to Merchants' Quarterly Report on Form 10-Q for the Quarter Ended September 30, 2006)

     

10.14.3

 

The Merchants Bancshares, Inc. 2008 Compensation Plan for Non-Employee Directors and Trustees

     

10.15

 

Agreement among the Merchants Bank and Kathryn T. Boardman, Thomas R. Havers and Susan D. Struble dated as of December 20, 1995 (Incorporated by reference to Exhibit 10.15 to Merchants' Annual Report on Form 10-K for the Year Ended December 31, 1996)

     

10.15.1

 

Trust under the Agreement among the Merchants Bank and Kathryn T. Boardman, Thomas R. Havers and Susan D. Struble dated as of December 20, 1995 (Incorporated by reference to Exhibit 10.15.1 to Merchants' Annual Report on Form 10-K for the Year Ended December 31, 1996)

     

10.16

 

Agreement between the Merchants Bank and Dudley H. Davis dated December 20, 1995 (Incorporated by reference to Exhibit 10.16 to Merchants' Annual Report on Form 10-K for the Year Ended December 31, 1996)

     

10.16.1

 

Fixed Trust under Agreement between the Merchants Bank and Dudley H. Davis dated December 20, 1995 (Incorporated by reference to Exhibit 10.16.1 to Merchants' Annual Report on Form 10-K for the Year Ended December 31, 1996)

<PAGE>  76

10.16.2

 

Variable Trust under Agreement between the Merchants Bank and Dudley H. Davis dated December 21, 1995 (Incorporated by reference to Exhibit 10.16.2 to Merchants' Annual Report on Form 10-K for the Year Ended December 31, 1996)

     

10.17

 

The Merchants Bancshares, Inc. Amended and Restated Stock Option Plan (Incorporated by reference to Exhibit 10.17 to Merchants' Annual Report on Form 10-K for the Year Ended December 31, 2006)

     

10.17.1

 

The Merchants Bancshares, Inc. 2008 Stock Option Plan

     

14

 

Code of Ethics (Incorporated by reference to Exhibit 14 to Merchants' Annual Report on Form 10-K for the Year Ended December 31, 2003)

     

21

 

Subsidiaries of Merchants

     

23

 

Consent of KPMG LLP

     

31.1

 

Certification of Chief Executive Officer of Merchants Pursuant to Securities Exchange Act Rules 13a-14 and 15d-14

     

31.2

 

Certification of Chief Financial Officer of Merchants Pursuant to Securities Exchange Act Rules 13a-14 and 15d-14

     

32.1

 

Certification of Chief Executive Officer of Merchants Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

     

32.2

 

Certification of Chief Financial Officer of Merchants Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

<PAGE>  77

SIGNATURES

 

Pursuant to the requirement of Section 13 or 15 (d) of the Securities Exchange Act of 1934 the registrant has duly caused this report to be signed on it's behalf by the undersigned, thereunto duly authorized.

 

Merchants Bancshares, Inc.

 

Date

March 12, 2008

 

By

/s/ Michael R. Tuttle

 


   


       

Michael R. Tuttle, President & CEO

 

Pursuant to the requirement of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of MERCHANTS BANCSHARES, INC., and in the capacities and on the date as indicated.

 

By

/s/ Michael R. Tuttle

 

March 12, 2008

 


 


 

Michael R. Tuttle, Director, President

 

Date

 

& CEO of Merchants

   
       

By

/s/ Peter A. Bouyea

 

March 12, 2008

 


 


 

Peter A. Bouyea, Director

 

Date

       

By

/s/ Jeffrey L. Davis

 

March 12, 2008

 


 


 

Jeffrey L. Davis, Director

 

Date

       

By

/s/ Michael G. Furlong

 

March 12, 2008

 


 


 

Michael G. Furlong, Director

 

Date

       

By

/s/ John A. Kane

 

March 12, 2008

 


 


 

John A. Kane, Director

 

Date

       

By

/s/ Lorilee A. Lawton

 

March 12, 2008

 


 


 

Lorilee A. Lawton, Director

 

Date

       

By

/s/ Bruce M. Lisman

 

March 12, 2008

 


 


 

Bruce M. Lisman, Director

 

Date

       

By

/s/ Raymond C. Pecor, Jr.

 

March 12, 2008

 


 


 

Raymond C. Pecor, Jr., Director,

 

Date

 

Chairman of the Board of Directors

   
       

By

/s/ Patrick S. Robins

 

March 12, 2008

 


 


 

Patrick S. Robins, Director

 

Date

       

By

/s/ Robert A. Skiff

 

March 12, 2008

 


 


 

Robert A. Skiff, Director

 

Date

       

By

/s/ Janet P. Spitler

 

March 12, 2008

 


 


 

Janet P. Spitler, Treasurer & CFO of Merchants

 

Date

<PAGE>  78