10-Q 1 d77151_mer10q.htm BODY OF FORM 10-Q                          MERCHANTS BANCSHARES, INC

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


FORM 10-Q



[ X ] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934


For the quarterly period ended

June 30, 2011


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 Other Jurisdiction of Incorporation or Organization)

 

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

 

275 Kennedy Drive, South Burlington, Vermont

 

05403

(Address of Principal Executive Offices)

 

(Zip Code)

 

802-658-3400

(Registrant’s Telephone Number, Including Area Code)

 

(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)


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 whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

[ X ] Yes    [    ] No


Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a nonaccelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.


Large Accelerated Filer [    ]

Accelerated Filer [ X ]

Nonaccelerated  Filer [    ]

Smaller Reporting Company [    ]


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

[    ] Yes                    [ X ] No


As of August 2, 2011, there were 6,218,121 shares of the registrant’s common stock, par value $0.01 per share, outstanding.



MERCHANTS BANCSHARES, INC.

FORM 10-Q

TABLE OF CONTENTS


PART I – FINANCIAL INFORMATION


 

Item 1.

 

Interim Consolidated Financial Statements (Unaudited)

 

 

 

 

 

 

 

 

 

 

 

Consolidated Balance Sheets
As of June 30, 2011 and December 31, 2010

 

1

 

 

 

 

 

 

 

 

 

Consolidated Statements of Income
For the three and six months ended June 30, 2011 and 2010

 

2

 

 

 

 

 

 

 

 

 

Consolidated Statements of Comprehensive Income
For the three and six months ended June 30, 2011 and 2010

 

3

 

 

 

 

 

 

 

 

 

Consolidated Statements of Cash Flows
For the six months ended June 30, 2011 and 2010

 

4

 

 

 

 

 

 

 

 

 

Notes to Interim Unaudited Consolidated Financial Statements

 

5 – 19

 

 

 

 

 

 

 

Item 2.

 

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

 

19 – 32

 

Item 3.

 

Quantitative and Qualitative Disclosures about Market Risk

 

32 - 34

 

Item 4.

 

Controls and Procedures

 

34

 

 

 

 

 

 

PART II – OTHER INFORMATION

 

 

 

 

 

 

 

 

 

Item 1.

 

Legal Proceedings

 

35

 

Item 1A.

 

Risk Factors

 

35

 

Item 2.

 

Unregistered Sales of Equity Securities and Use of Proceeds

 

35

 

Item 3.

 

Defaults upon Senior Securities

 

35

 

Item 4.

 

(Removed and Reserved)

 

35

 

Item 5.

 

Other Information

 

35

 

Item 6.

 

Exhibits

 

35 - 36

 

Signatures

 

36

 

Exhibits

 

 






MERCHANTS BANCSHARES, INC.

PART I - FINANCIAL INFORMATION


ITEM 1.  Financial Statements


Merchants Bancshares, Inc.

Consolidated Balance Sheets

(unaudited)

(In thousands except share and per share data)

 

 

June 30,
2011

 

December 31,
2010

ASSETS

 

 

 

 

 

    Cash and due from banks

 

 

$     10,820 

 

$     11,753 

    Interest earning deposits with banks and other short-term investments

 

 

38,513 

 

62,273 

        Total cash and cash equivalents

 

 

49,333 

 

74,026 

    Investments:

 

 

 

 

 

        Securities available for sale, at fair value

 

 

404,879 

 

465,962 

        Securities held to maturity (fair value of $725 and $882)

 

 

651 

 

794 

            Total investments

 

 

405,530 

 

466,756 

    Loans

 

 

943,350 

 

910,794 

    Less: Allowance for loan losses

 

 

10,438 

 

10,135 

            Net loans

 

 

932,912 

 

900,659 

    Federal Home Loan Bank stock

 

 

8,630 

 

8,630 

    Bank premises and equipment, net

 

 

14,100 

 

14,365 

    Investment in real estate limited partnerships

 

 

4,959 

 

5,253 

    Other assets

 

 

15,343 

 

17,955 

            Total assets

 

 

$1,430,807 

 

$1,487,644 

LIABILITIES

 

 

 

 

 

    Deposits:

 

 

 

 

 

        Demand (noninterest bearing)

 

 

$   161,140 

 

$   141,412 

        Savings, interest bearing checking and money market accounts

 

 

586,837 

 

584,582 

        Time deposits $100 thousand and greater

 

 

123,816 

 

127,749 

        Other time deposits

 

 

231,305 

 

238,453 

            Total deposits

 

 

1,103,098 

 

1,092,196 

    Short term debt

 

 

2,214 

 

2,964 

    Securities sold under agreements to repurchase

 

 

160,494 

 

232,193 

    Long-term debt

 

 

31,100 

 

31,139 

    Junior subordinated debentures issued to unconsolidated subsidiary trust

 

 

20,619 

 

20,619 

    Other liabilities

 

 

8,496 

 

9,202 

            Total liabilities

 

 

1,326,021 

 

1,388,313 

    Commitments and contingencies (Note 8)

 

 

 

 

 

SHAREHOLDERS' EQUITY

 

 

 

 

 

    Preferred stock

 

 

 

 

 

        Class A non-voting shares authorized – 200,000, none outstanding

 

 

 

        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 June 30, 2011 and December 31, 2010

6,651,760

 

 

 

 

        Outstanding

As of June 30, 2011

5,900,682

 

 

 

 

 

As of December 31, 2010

5,859,263

 

 

 

 

    Capital in excess of par value

 

 

36,448 

 

36,348 

    Retained earnings

 

 

74,987 

 

71,725 

    Treasury stock, at cost

 

 

(15,952)

 

(16,836)

 

As of June 30, 2011

751,078

 

 

 

 

 

As of December 31, 2010

792,497

 

 

 

 

    Deferred compensation arrangements

 

 

5,932 

 

6,350 

    Accumulated other comprehensive income

 

 

3,304 

 

1,677 

            Total shareholders' equity

 

 

104,786 

 

99,331 

            Total liabilities and shareholders' equity

 

 

$1,430,807 

 

$1,487,644 


See accompanying notes to interim unaudited consolidated financial statements




1




Merchants Bancshares, Inc.

Consolidated Statements of Income

(Unaudited)


 

Three Months Ended
June 30,

Six Months Ended
June 30,

(In thousands except per share data)

2011

2010

2011

2010

INTEREST AND DIVIDEND INCOME

 

    Interest and fees on loans

$11,190 

$11,602 

$22,189 

$23,091 

    Investment income:

 

        Interest and dividends on investment securities

3,508 

3,831 

6,530 

7,553 

        Interest on interest earning deposits with banks and other
         short-term investments

14 

24 

44 

45 

            Total interest and dividend income

14,712 

15,457 

28,763 

30,689 

INTEREST EXPENSE

 

    Savings, NOW and money market accounts

292 

369 

616 

758 

    Time deposits $100 thousand and greater

296 

318 

608 

691 

    Other time deposits

544 

735 

1,109 

1,537 

    Securities sold under agreement to repurchase

572 

878 

1,164 

1,776 

    Long-term debt

214 

216 

427 

428 

    Junior subordinated debentures issued to unconsolidated subsidiary trust

301 

300 

594 

593 

            Total interest expense

2,219 

2,816 

4,518 

5,783 

    Net interest income

12,493 

12,641 

24,245 

24,906 

    Provision for credit losses

250 

250 

600 

    Net interest income after provision for credit losses

12,243 

12,641 

23,995 

24,306 

NONINTEREST INCOME

 

    Total other-than-temporary impairment losses

34 

211 

    Portion of loss recognized in other comprehensive income (before taxes)

(34)

(291)

    Net impairment losses

(80)

    Gain (loss) on investment securities, net

137 

503 

127 

1,212 

    Trust company income

632 

533 

1,255 

1,051 

    Service charges on deposits

1,072 

1,395 

2,034 

2,634 

    Equity in losses of real estate limited partnerships

(426)

(421)

(883)

(855)

    Other noninterest income

1,145 

1,145 

2,120 

2,103 

            Total noninterest income

2,560 

3,155 

4,653 

6,065 

NONINTEREST EXPENSE

 

 

 

 

    Compensation and benefits

5,134 

5,009 

10,293 

9,980 

    Occupancy expense

951 

911 

1,992 

1,841 

    Equipment expense

813 

710 

1,602 

1,390 

    Legal and professional fees

774 

664 

1,377 

1,255 

    Marketing and advertising expense

445 

366 

784 

681 

    State franchise taxes

317 

295 

630 

574 

    FDIC insurance

194 

340 

546 

720 

    Other Real Estate Owned ("OREO") expenses (income)

65 

(196)

81 

(390)

    Other noninterest expense

1,513 

1,522 

3,012 

3,036 

            Total noninterest expense

10,206 

9,621 

20,317 

19,087 

Income before provision for income taxes

4,597 

6,175 

8,331 

11,284 

Provision for income taxes

968 

1,589 

1,601 

2,869 

NET INCOME

$  3,629 

$  4,586 

$  6,730 

$  8,415 

 

 

 

 

 

Basic earnings per common share

$    0.58 

$    0.74 

$    1.09 

$    1.37 

Diluted earnings per common share

$    0.58 

$    0.74 

$    1.08 

$    1.37 


See accompanying notes to interim unaudited consolidated financial statements




2




Merchants Bancshares, Inc.

Consolidated Statements of Comprehensive Income

(Unaudited)


 

Three Months Ended
June 30,

Six Months Ended
June 30,

(In thousands)

2011

2010

2011

2010

Net income

$3,629 

$4,586 

$6,730 

$8,415 

Other comprehensive income, net of tax:

 

    Change in net unrealized gain on securities available for sale,
     net of taxes of $1,034, $840, $869 and $1,419

1,921 

1,560 

1,614 

2,635 

    Reclassification adjustments for net securities losses (gains) included in net
     income, net of taxes of $(48), $(176), $(44) and $(424)

(89)

(327)

(83)

(788)

    Change in net unrealized loss on interest rate swaps, net of taxes
     of $(72), $(186), $3 and $(262)

(134)

(345)

(487)

    Pension liability adjustment, net of taxes of $25, $16, $49 and $42

45 

30 

91 

79 

Other comprehensive income

1,743 

918 

1,627 

1,439 

Comprehensive income

$5,372 

$5,504 

$8,357 

$9,854 


See accompanying notes to interim unaudited consolidated financial statements




3




Merchants Bancshares, Inc.

Consolidated Statements of Cash Flows

(Unaudited)


For the six months ended June 30,

 

2011

 

2010

(In thousands)

 

 

 

 

CASH FLOWS FROM OPERATING ACTIVITIES:

 

 

 

 

Net income

 

$     6,730 

 

$     8,415 

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

 

 

 

 

    Provision for credit losses

 

250 

 

600 

    Depreciation and amortization

 

3,702 

 

2,586 

    Stock option expense

 

72 

 

36 

    Net gains on sales of investment securities

 

(127)

 

(1,212)

    Other-than-temporary impairment losses on investment securities

 

 

80 

    Net gains on sale of loans

 

(16)

 

(12)

    Net gains on sale of premises and equipment

 

(7)

 

    Gains on sale of other real estate owned

 

(33)

 

(552)

    Equity in losses of real estate limited partnerships, net

 

883 

 

855 

Changes in assets and liabilities:

 

 

 

 

    Decrease (increase) in interest receivable

 

414 

 

(94)

    Decrease (increase) in other assets

 

1,132 

 

(2,722)

    Decrease in interest payable

 

(37)

 

(91)

    Decrease in other liabilities

 

(365)

 

(1,943)

        Net cash provided by operating activities

 

12,598 

 

5,946 

CASH FLOWS FROM INVESTING ACTIVITIES:

 

 

 

 

    Proceeds from sales of investment securities available for sale

 

77,030 

 

30,039 

    Proceeds from maturities of investment securities available for sale

 

94,507 

 

91,418 

    Proceeds from maturities of investment securities held to maturity

 

143 

 

204 

    Purchases of investment securities available for sale

 

(110,758)

 

(132,058)

    Loan originations less than principal payments

 

(32,696)

 

20,115 

    Proceeds from sales of loans, net

 

53 

 

290 

    Proceeds from sales of premises and equipment

 

51 

 

    Proceeds from sales of other real estate owned

 

224 

 

1,392 

    Real estate limited partnership investments

 

(588)

 

(234)

    Purchases of bank premises and equipment

 

(696)

 

(989)

        Net cash provided by investing activities

 

27,270 

 

10,177 

CASH FLOWS FROM FINANCING ACTIVITIES:

 

 

 

 

    Net increase (decrease) in deposits

 

10,902 

 

(6,247)

    Net (decrease) increase in short-term borrowings

 

(750)

 

12,272 

    Net decrease in securities sold under agreement to repurchase

 

(71,699)

 

(55,529)

    Principal payments on long-term debt

 

(39)

 

(38)

    Cash dividends paid

 

(3,115)

 

(3,061)

    Sale of treasury stock

 

28 

 

    Increase in deferred compensation arrangements

 

112 

 

105 

        Net cash used in financing activities

 

(64,561)

 

(52,498)

Decrease in cash and cash equivalents

 

(24,693)

 

(36,375)

Cash and cash equivalents beginning of period

 

74,026 

 

74,546 

Cash and cash equivalents end of period

 

$   49,333 

 

$   38,171 

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:

 

 

 

 

    Total interest payments

 

$     4,555 

 

$     5,873 

    Total income tax payments

 

500 

 

4,100 

SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING
 ACTIVITIES:

 

 

 

 

    Distribution of stock under deferred compensation arrangements

 

432 

 

455 

    Distribution of treasury stock in lieu of cash dividend

 

353 

 

383 

    Transfer of loans to other real estate owned

 

 

629 

    Restricted stock grants

 

269 

 


See accompanying notes to interim unaudited consolidated financial statements




4




Notes To Interim Unaudited Consolidated Financial Statements


For additional information, see the Merchants Bancshares, Inc. (“Merchants,” “we,” “us,” “our”) Annual Report on Form 10-K for the fiscal year ended December 31, 2010, filed with the Securities and Exchange Commission (the “SEC”) on March 15, 2011.


Note 1: Financial Statement Presentation


Principles of Consolidation

The accompanying unaudited interim consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and the instructions to the Quarterly Report on Form 10-Q and Rule 10-01 of Regulation S-X promulgated under the Securities Exchange Act of 1934, as amended. Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States of America for complete financial statements. All adjustments necessary for a fair presentation of our interim consolidated financial statements as of June 30, 2011 and December 31, 2010 and for the three and six months ended June 30, 2011 and 2010 have been included. The information was prepared from our unaudited financial statements and the unaudited financial statements of our subsidiaries, Merchants Bank and MBVT Statutory Trust I. Amounts reported for prior periods are reclassified, where necessary, to be consistent with the current period presentation.


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 us 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, interest income recognition on loans and investments and analysis of other-than-temporary impairment of investment securities. Operating results in the future may vary from the amounts derived from our estimates and assumptions.


Note 2: Investment Securities


Investments in securities are classified as available for sale or held to maturity as of June 30, 2011. The amortized cost and fair values of the securities classified as available for sale and held to maturity as of June 30, 2011 and December 31, 2010 are as follows:


(In thousands)

Amortized
Cost

 

Gross
Unrealized
Gains

 

Gross
Unrealized
Losses

 

Fair
Value

As of June 30, 2011

 

 

 

 

 

 

 

Available for Sale:

 

 

 

 

 

 

 

U.S. Treasury Obligations

$       250

 

$         0

 

$    0

 

$       250

U.S. Agency Obligations

87,907

 

564

 

61

 

88,410

Federal Home Loan Bank ("FHLB") Obligations

11,826

 

323

 

0

 

12,149

Residential Real Estate Mortgage-backed Securities ("Agency
 MBSs")

176,548

 

6,998

 

11

 

183,535

Agency Collateralized Mortgage Obligations ("Agency CMOs")

111,472

 

2,245

 

37

 

113,680

Non-agency Collateralized Mortgage Obligations ("Non-
 agency CMOs")

5,820

 

1

 

316

 

5,505

Asset Backed Securities ("ABSs")

1,357

 

48

 

55

 

1,350

Total Available for Sale

$395,180

 

$10,179

 

$480

 

$404,879

Held to Maturity:

 

 

 

 

 

 

 

Agency MBSs

651

 

74

 

0

 

725

Total Agency MBSs

$       651

 

$       74

 

$    0

 

$       725





5





As of December 31, 2010

 

 

 

 

 

 

 

Available for Sale:

 

 

 

 

 

 

 

U.S. Treasury Obligations

$       250

 

$       0

 

$       0

 

$       250

U.S. Agency Obligations

47,717

 

287

 

216

 

47,788

FHLB Obligations

11,211

 

253

 

7

 

11,457

Agency MBSs

169,396

 

6,136

 

625

 

174,907

Agency CMOs

222,435

 

2,289

 

456

 

224,268

Non-agency CMOs

6,114

 

2

 

264

 

5,852

ABS

1,492

 

0

 

52

 

1,440

Total Available for Sale

$458,615

 

$8,967

 

$1,620

 

$465,962

Held to Maturity:

 

 

 

 

 

 

 

Agency MBSs

794

 

88

 

0

 

882

Total Agency MBSs

$       794

 

$     88

 

$       0

 

$       882


Included in gross unrealized losses at June 30, 2011 are $55 thousand of non-credit related unrealized losses on other-than-temporarily impaired securities in the ABS portfolio, which are included in accumulated other comprehensive income, net of tax.


The contractual final maturity distribution of the debt securities classified as available for sale and held to maturity as of June 30, 2011 and December 31, 2010, are as follows:


(In thousands)

Within
One Year

 

After One
But Within
Five Years

 

After Five
But Within
Ten Years

 

After Ten
Years

 

Total

As of June 30, 2011

 

 

 

 

 

 

 

 

 

Available for Sale (at fair value):

 

 

 

 

 

 

 

 

 

U.S. Treasury Obligations

$       0

 

$     250

 

$           0

 

$           0

 

$       250

U.S. Agency Obligations

3,034

 

10,068

 

61,398

 

13,910

 

88,410

FHLB Obligations

3,936

 

0

 

8,213

 

0

 

12,149

Agency MBSs

217

 

7,059

 

35,493

 

140,766

 

183,535

Agency CMOs

0

 

0

 

6,117

 

107,563

 

113,680

Non-agency CMOs

0

 

0

 

54

 

5,451

 

5,505

ABSs

0

 

0

 

0

 

1,350

 

1,350

Total Available for Sale

$7,187

 

$17,377

 

$111,275

 

$269,040

 

$404,879

Held to Maturity:

 

 

 

 

 

 

 

 

 

Agency MBSs

0

 

213

 

0

 

438

 

651

Total Agency MBSs

$       0

 

$     213

 

$           0

 

$       438

 

$       651

 

 

 

 

 

 

 

 

 

 

As of December 31, 2010

 

 

 

 

 

 

 

 

 

Available for Sale (at fair value):

 

 

 

 

 

 

 

 

 

U.S. Treasury Obligations

$   250

 

$         0

 

$           0

 

$           0

 

$       250

U.S. Agency Obligations

0

 

9,042

 

30,902

 

7,844

 

47,788

FHLB Obligations

0

 

4,428

 

7,029

 

0

 

11,457

Agency MBSs

2,146

 

7,425

 

36,877

 

128,459

 

174,907

Agency CMOs

430

 

0

 

18,180

 

205,658

 

224,268

Non-agency CMOs

0

 

0

 

72

 

5,780

 

5,852

ABSs

0

 

0

 

0

 

1,440

 

1,440

Total Available for Sale

$2,826

 

$20,895

 

$  93,060

 

$349,181

 

$465,962

Held to Maturity:

 

 

 

 

 

 

 

 

 

Agency MBSs

3

 

192

 

85

 

514

 

794

Total Agency MBSs

$       3

 

$     192

 

$         85

 

$       514

 

$       794


Actual maturities will differ from contractual maturities because borrowers may have rights to call or prepay obligations. Maturities of Agency MBSs and Agency CMOs are based on final contractual maturities.




6




Proceeds from sales of available for sale debt securities were $77.03 million for the first six months of 2011. Gross gains of $204 thousand and $218 thousand and gross losses of $67 thousand and $91 thousand were realized from these sales for the three and six months ended June 30, 2011, respectively.


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 June 30, 2011 and December 31, 2010, were as follows:


 

Less than 12 months

 

12 months or more

 

Total

(In thousands)

Fair Value

 

Loss

 

Fair Value

 

Loss

 

Fair Value

 

Loss

As of June 30, 2011

 

 

 

 

 

 

 

 

 

 

 

U.S. Agency Obligations

$  14,769

 

$     61

 

$       0

 

$    0

 

$  14,769

 

$     61

FHLB Obligations

0

 

0

 

0

 

0

 

0

 

0

Agency MBSs

4,610

 

11

 

0

 

0

 

4,610

 

11

Agency CMOs

10,970

 

37

 

0

 

0

 

10,970

 

37

Non-agency CMOs

94

 

2

 

5,357

 

314

 

5,451

 

316

ABSs

0

 

0

 

945

 

55

 

945

 

55

Total

$  30,443

 

$   111

 

$6,302

 

$369

 

$  36,745

 

$   480

As of December 31, 2010

 

 

 

 

 

 

 

 

 

 

 

U.S. Agency Obligations

$  16,173

 

$   216

 

$       0

 

$    0

 

$  16,173

 

$   216

FHLB Obligations

4,989

 

7

 

0

 

0

 

4,989

 

7

Agency MBSs

61,276

 

625

 

0

 

0

 

61,276

 

625

Agency CMOs

86,542

 

456

 

0

 

0

 

86,542

 

456

Non-agency CMOs

96

 

2

 

5,684

 

262

 

5,780

 

264

ABSs

349

 

7

 

1,090

 

45

 

1,439

 

52

Total

$169,425

 

$1,313

 

$6,774

 

$307

 

$176,199

 

$1,620


There were no securities held to maturity with unrealized losses as of June 30, 2011 and December 31, 2010.


Unrealized losses on investment securities result from the cost basis of the security being higher than its current fair value. These discrepancies generally occur because of changes in interest rates since the time of purchase, or because the credit quality of the issuer or underlying collateral has deteriorated. We perform a quarterly analysis of each security in our portfolio to determine if impairment exists, and if it does, whether that impairment is other-than-temporary.


Agency MBSs and Agency CMOs consist of pools of residential mortgages which are guaranteed by the Federal National Mortgage Association (“FNMA”), Federal Home Loan Mortgage Corporation (“FHLMC”), or the Government National Mortgage Association (“GNMA”) with various origination dates and maturities. Non-Agency CMOs and ABSs are tracked individually by our investment manager with updates on the performance of the underlying collateral provided at least quarterly. Additionally, our investment manager performs stress testing of individual bonds that experience greater levels of market volatility.


The non-Agency CMO portfolio consists of four bonds, two with balances less than $100 thousand and an insignificant unrealized loss. We performed no additional analysis on these bonds. Management has performed analyses on the remaining two bonds. One of the bonds, with a book value of $3.79 million and a fair value of $3.52 million at June 30, 2011, is rated AA by Fitch and Baa3 by Moody’s. Delinquencies have been fairly low and prepayments have led to increased credit support. The bond is backed by a large pool of loans with a 2004 issue date, 60-plus day delinquencies have been moderate and steady over the life of the bond, credit scores are high and loan-to-value ratios (“LTVs”) are low. The second bond has a book value of $1.88 million and a fair value of $1.84 million. This bond is rated CCC by Fitch and A- by S&P. Delinquencies on this bond have generally been fairly low, particularly within our tranche, and prepayments have led to increased credit support. A relatively small loan pool and high average loan size are mitigated by low 60-plus day delinquencies, high credit scores, low LTVs and a 2005 issue date. Our investment advisor has assisted Management in running various cash flow analyses on the bonds to determine the likelihood of a principal loss in the future. In all cases, the likelihood of a loss in excess of our book value was determined to be remote.





7




The ABS portfolio consists of two bonds, one of which, with a book value of $357 thousand and a current market value of $405 thousand, is in an unrealized gain position, and, additionally, carries an Agency guarantee. We have performed no further analysis on this bond. The second bond in the ABS portfolio has insurance backing from Ambac. However, because of Ambac’s uncertain financial status, we place no reliance on the insurance wrap in its impairment analysis. The bond is rated CC by Standard & Poor’s and Caa2 by Moody’s. We previously recorded impairment charges on this bond totaling $122 thousand. The book value of the bond, net of the impairment charges, is $1.00 million, and its current market value is $945 thousand. This is the only bond in our bond portfolio with subprime exposure. Principal payments received on the bond during 2011 total $135 thousand. We have performed the same analysis on this bond as on our non-Agency CMOs discussed above and consider its additional impairment temporary.


As a member of the FHLB system, we are required to invest in stock of the FHLB of Boston (the “FHLBB”) in an amount determined based on our borrowings from the FHLBB. At June 30, 2011, our investment in FHLBB stock totaled $8.63 million. We received dividend income totaling $6 thousand and $13 thousand during the quarter and six months ended June 30, 2011, respectively.


We do not intend to sell the investment securities that are in an unrealized loss position, and it is unlikely that we will be required to sell the investment securities before recovery of their amortized cost bases, which may be maturity.


Note 3: Loans and the allowance for credit losses


Loans

The composition of the loan portfolio at June 30, 2011 and December 31, 2010 is as follows:


(In thousands)

June 30, 2011

December 31, 2010

Commercial, financial and agricultural

$165,665

$ 112,514

Municipal loans

37,933

67,861

Real estate loans – residential

418,246

422,981

Real estate loans – commercial

304,347

284,296

Real estate loans – construction

10,303

16,420

Installment loans

6,319

6,284

All other loans

537

438

Total loans

$943,350

$ 910,794


At June 30, 2011 and December 31, 2010, total loans included $28 thousand and $80 thousand of net deferred loan origination fees. The aggregate amount of overdrawn deposit balances classified as loan balances was $537 thousand and $437 thousand at June 30, 2011 and December 31, 2010, respectively.


Residential and commercial loans serviced for others at June 30, 2011 and December 31, 2010 amounted to approximately $21.30 million and $19.41 million, respectively.


We primarily originate residential real estate, commercial, commercial real estate, municipal obligations and installment loans to customers throughout the state of Vermont. There are no significant industry concentrations in the loan portfolio. Economic conditions have continued to improve during 2011, but there are remaining areas of weakness. While continuing to adhere to prudent underwriting standards, we are not immune to some negative consequences arising from overall economic weakness and, in particular, a sharp downturn in the real estate market in Vermont.


Allowance for Credit Losses

We have divided the loan portfolio into portfolio segments, each with different risk characteristics and methodologies for assessing risk. Each portfolio segment is broken down into classes where appropriate. Portfolio classes contain unique measurement attributes, risk characteristics and methods for monitoring and assessing risk that are necessary to develop the allowance for loan and lease losses. Unique characteristics such as borrower type, loan type, collateral type, and risk characteristics define each portfolio class. A description of each portfolio segment follows:


Commercial, financial and agricultural: We offer a variety of loan options to meet the specific needs of commercial customers, including term loans and lines of credit. Such loans are made available to businesses for working capital such as inventory and receivables, business expansion and equipment purchases. Generally, a collateral lien is placed on equipment, receivables, inventory or other assets owned by the borrower. These loans carry a higher risk than commercial real estate loans by the nature of the underlying collateral, and the collateral value may change daily. To reduce the risk, management generally employs enhanced monitoring requirements, obtains personal guarantees and, where appropriate, may also attempt to secure real estate as collateral.




8




Municipal: Municipal loans primarily consist of shorter term loans issued on a tax-exempt basis which are considered general obligations of the municipality. These loans are generally viewed as lower risk and self-liquidating, as Vermont statutes mandate that a municipality utilize its taxing power to meet its financial obligations. To a lesser extent, we also make longer term municipal loans, which are also considered general obligations of the municipality. Most of the longer term loans were originated under the federal Qualified School Construction Bond program. Proceeds are used for the construction, rehabilitation or repair of public school properties, and we receive a federal tax credit in lieu of interest income on these loans.


Real Estate – Residential: Residential real estate loans consist primarily of loans secured by first or second mortgages on primary residences. We originate adjustable-rate and fixed-rate, one- to four-family residential real estate loans for the construction, purchase or refinancing of a mortgage. These loans are collateralized by owner-occupied properties located in our market area. Loans on one- to four-family residential real estate are generally originated in amounts of no more than 80% of the purchase price or appraised value (whichever is lower). Mortgage title insurance and hazard insurance are required.


Real Estate – Commercial: We offer commercial real estate loans to finance real estate purchases and refinancing of existing commercial properties. These commercial real estate loans are secured by first liens on the real estate, which may include both owner-occupied and non-owner occupied facilities. The types of facilities financed include apartments, hotels, warehouses, retail facilities, manufacturing facilities and office buildings. These loans may be less risky than commercial loans, since they are secured by real estate and buildings. Our underwriting analysis includes credit verification, independent appraisals, a review of the borrower's financial condition, and a detailed analysis of the borrower’s underlying cash flows. These loans are typically originated in amounts of no more than 75% of the appraised value of the property.


Real Estate – Construction: We offer construction loans for the construction, expansion and improvement of residential and commercial properties which are secured by the real estate being developed. A review of all plans and budgets is performed prior to approval, third party progress documents are required during construction, and an independent approval process for all draw and release requests is maintained to ensure that funding is prudently administered and that funds are sufficient to complete the project.


Installment: We offer traditional direct consumer installment loans for various personal needs, including vehicle and boat financing. The vast majority of these loans are secured by a lien on the purchased vehicle and are underwritten using credit scores and income verification. The bank does not provide any indirect consumer lending activities.


For purposes of evaluating the adequacy of the allowance for credit losses, we consider a number of significant factors that affect the collectability of the portfolio. For individually evaluated loans, these include estimates of loss exposure, which reflect the facts and circumstances that affect the likelihood of repayment of such loans as of the evaluation date. For homogeneous pools of loans, estimates of our exposure to credit loss reflect a current assessment of a number of factors, which could affect collectability. These factors include: past loss experience; size, trend, composition, and nature of loans; changes in lending policies and procedures, including underwriting standards and collection, charge-offs and recoveries; trends experienced in nonperforming and delinquent loans; current economic conditions in our market; the effect of external factors such as competition, legal and regulatory requirements; and the experience, ability, and depth of lending management and staff. In addition, an external loan review firm and various regulatory agencies periodically review our allowance for credit losses. 


After a thorough consideration of the factors discussed above, any required additions to the allowance for credit losses are made periodically by charges to the provision for credit losses. These charges are necessary to maintain the allowance for credit losses at a level which management believes is reasonably reflective of overall inherent risk of probable loss in the portfolio. While management uses available information to recognize losses on loans, additions may fluctuate from one reporting period to another. These fluctuations are reflective of changes in risk associated with portfolio content and/or changes in management’s assessment of any or all of the determining factors discussed above. The following table reflects our loan loss experience and activity in the Allowance for Credit Losses for the first six months of 2011:




9





(In thousands)

Commercial,
financial and
agricultural

Municipal

Real estate -
residential

Real estate -
commercial

Real estate -
construction

Installment

All
other

Totals

Allowance for credit
 losses:

 

 

 

 

 

 

 

 

Beginning balance

$    2,617 

$     236 

$    2,428 

$    5,143 

$     283 

$     24 

$  23

$  10,754 

Chargeoffs

(77)

(49)

(60)

(11)

(8)

0

(205)

Recoveries

44 

43 

11 

0

102 

Provision

538 

(121)

183 

(270)

(90)

4

250 

Ending balance

$    3,122 

$     115 

$    2,563 

$    4,856 

$     193 

$     25 

$  27

$  10,901 

 

 

 

 

 

 

 

 

 

Ending balance
 individually evaluated
 for impairment

$       130 

$         0 

$         79 

$           0 

$         0 

$       0 

$    0

$     209 

Ending balance
 collectively evaluated
 for impairment

2,992 

115 

2,484 

4,856 

193 

25 

27

10,692 

Totals

$    3,122 

$     115 

$    2,563 

$    4,856 

$     193 

$     25 

$  27

$  10,901 

 

 

 

 

 

 

 

 

 

Financing receivables:

 

 

 

 

 

 

 

 

Ending balance
 individually evaluated
 for impairment

$       428 

$         0 

$    2,199 

$       656 

$     158 

$       3 

$    0

$    3,444 

Ending balance
 collectively evaluated
 for impairment

165,237 

37,933 

416,047 

303,691 

10,145 

6,316 

537

939,906 

Totals

$165,665 

$37,933 

$418,246 

$304,347 

$10,303 

$6,319 

$537

$943,350 


Components:

Allowance for loan losses

$    2,806 

$     115 

$    2,492 

$    4,796 

$     177 

$     25 

$  27

$  10,438 

Reserve for undisbursed
 lines of credit

316 

71 

60 

16 

0

463 

Total

$    3,122 

$     115 

$    2,563 

$    4,856 

$     193 

$     25 

$  27

$  10,901 


Presented below is an aging of past due loans, including nonaccrual loans, by class as of June 30, 2011:


(In thousands)

30-59
Days
Past
Due

60-89
Days
Past
Due

Over 90
Days
Past
Due

Total
Past Due

Current

Total

Greater
Than 90
Days and
Accruing

 

 

 

 

 

 

 

 

Commercial, financial and agricultural

$    0

$    0

$     45

$     45

$165,620

$165,665

$0

Municipal

0

0

0

0

37,933

37,933

0

Real estate – residential:

 

 

 

 

 

 

 

    First mortgage

176

918

866

1,960

377,075

379,035

0

    Second mortgage

10

0

302

312

38,899

39,211

0

Real estate – commercial:

 

 

 

 

 

 

 

    Owner occupied

0

0

147

147

141,952

142,099

0

    Non-owner occupied

0

0

0

0

162,248

162,248

0

Real estate – construction:

 

 

 

 

 

 

 

    Residential

0

0

0

0

2,005

2,005

0

    Commercial

0

0

158

158

8,140

8,298

0

Installment

3

1

3

7

6,312

6,319

0

Other

0

0

0

0

537

537

0

Total

$189

$919

$1,521

$2,629

$940,721

$943,350

$0




10




Presented below is an aging of past due loans, including nonaccrual loans, by class as of December 31, 2010:


(In thousands)

30-59
Days
Past
Due

60-89
Days
Past
Due

Over 90
Days
Past
Due

Total
Past Due

Current

Total

Greater
Than 90
Days and
Accruing

 

 

 

 

 

 

 

 

Commercial, financial and agricultural

$  38

$     88

$   169

$   295

$112,219

$112,514

$    0

Municipal

0

0

0

0

67,861

67,861

0

Real estate – residential:

 

 

 

 

 

 

 

    First mortgage

0

743

1,461

2,204

378,508

380,712

216

    Second mortgage

128

118

491

737

41,532

42,269

168

Real estate – commercial:

 

 

 

 

 

 

 

    Owner occupied

186

0

445

631

125,325

125,956

0

    Non-owner occupied

0

21

400

421

157,919

158,340

0

Real estate – construction:

 

 

 

 

 

 

 

    Residential

0

0

0

0

6,287

6,287

0

    Commercial

0

167

0

167

9,966

10,133

0

Installment

20

6

0

26

6,258

6,284

0

Other

5

0

0

5

433

438

0

Total

$377

$1,143

$2,966

$4,486

$906,308

$910,794

$384


Impaired loans by class at June 30, 2011 were as follows:


(In thousands)

Recorded
Investment

Unpaid
Principal
Balance

Related
Allowance

Average
Recorded
Investment

Interest
Income
Recognized

With no related allowance recorded

 

 

 

 

 

Commercial, financial and agricultural

$   133

$1,196

$    0

$   186

$0

Real estate – residential

 

 

 

 

 

    First mortgage

1,131

1,373

0

1,180

0

    Second mortgage

328

328

0

443

0

Real estate – commercial

 

 

 

 

 

    Owner occupied

475

475

0

474

0

    Non-owner occupied

181

251

0

69

0

Real estate – construction

 

 

 

 

 

    Residential

0

0

0

0

0

    Commercial

158

325

0

161

0

Installment

3

27

0

4

0

With related allowance recorded

 

 

 

 

 

Commercial, financial and agricultural

295

295

130

390

0

Real estate – residential

 

 

 

 

 

    First mortgage

681

681

76

628

0

    Second mortgage

59

59

3

10

0

Real estate – commercial

 

 

 

 

 

    Non-owner occupied

0

0

0

92

0

Total

 

 

 

 

 

Commercial, financial and agricultural

428

1,491

130

576

0

Real estate – residential

2,199

2,441

79

2,261

0

Real estate – commercial

656

726

0

635

0

Real estate – construction

158

325

0

161

0

Installment and other

3

27

0

4

0

Total

$3,444

$5,010

$209

$3,637

$0




11




Impaired loans by class at December 31, 2010 were as follows:


(In thousands)

Recorded
Investment

Unpaid
Principal
Balance

Related
Allowance

With no related allowance recorded:

 

 

 

    Commercial, financial and agricultural

$   112

$1,077

$    0

    Real estate – residential:

 

 

 

        First mortgage

1,318

1,636

0

        Second mortgage

644

644

0

    Real estate – commercial:

 

 

 

        Owner occupied

483

490

0

        Non-owner occupied

400

640

0

    Installment

0

17

0

With related allowance recorded

 

 

 

    Commercial, financial and agricultural

483

483

275

    Real estate – residential:

 

 

 

        First mortgage

664

664

58

Total:

 

 

 

    Commercial, financial and agricultural

595

1,560

275

    Real estate – residential

2,626

2,944

58

    Real estate – commercial

883

1,130

0

    Installment

0

17

0

        Total

$4,104

$5,651

$333


Impaired loans at June 30, 2011 consist primarily of residential real estate loans. Total impaired loans totaled $3.44 million and $4.10 million at June 30, 2011 and December 31, 2010, respectively. At June 30, 2011, $1.04 million of the impaired loans had a specific reserve allocation of $209 thousand, and $2.40 million of the impaired loans had no specific reserve allocation. At December 31, 2010, $1.15 million of the impaired loans had a specific reserve allocation of $333 thousand, and $2.96 million of the impaired loans had no specific reserve allocation. We recorded interest income on impaired loans of approximately $7 thousand during the six months ended June 30, 2011. No interest was recorded on a cash basis during the period the loans were impaired. The average balance of impaired loans was $3.64 million during the six months ended June 30, 2011.


Nonperforming loans at June 30, 2011 and December 31, 2010 were as follows:


(In thousands)

June 30,
2011

December 31,
2010

Nonaccrual loans

$3,071

$3,317

Troubled debt restructured loans (“TDRs”)

373

403

Loans greater than 90 days and accruing

0

384

Total nonperforming loans

$3,444

$4,104


TDRs consist of three residential real estate loans; one of the loans was restructured with longer terms at market rates and two were restructured with rate concessions, all are performing in accordance with modified agreements with the borrowers at June 30, 2011. There have been no defaults on TDRs. There were no commitments to lend additional funds to borrowers whose loans have been modified in a troubled debt restructuring at June 30, 2011. We had no commitments to lend additional funds to borrowers whose loans were in nonaccrual status and no commitments to lend additional funds to borrowers whose loans were 90 days past due and still accruing. We had no OREO at June 30, 2011 and a balance of $191 thousand at December 31, 2010.




12




Nonaccrual loans by class as of June 30, 2011 and December 31, 2010 were as follows:


(In thousands)

June 30,
2011

December 31,
2010

Commercial, financial and agricultural

$   428

$   595

Real estate – residential:

 

 

    First mortgage

1,525

1,486

    Second mortgage

301

391

Real estate – commercial:

 

 

    Owner occupied

475

445

    Non owner occupied

181

400

Real estate – construction:

 

 

    Commercial

158

0

     Installment

3

0

Total nonaccrual loans

$3,071

$3,317


Commercial Grading System

We use risk rating definitions for our commercial loan portfolios and certain residential loans which are generally consistent with regulatory and banking industry norms. Loans are assigned a credit quality grade which is based upon management’s on-going assessment of risk based upon an evaluation of the quantitative and qualitative aspects of each credit. This assessment is a dynamic process and risk ratings are adjusted as each borrower’s financial situation changes. This process is designed to provide timely recognition of a borrower’s financial condition and appropriately focus management resources.


Pass rated loans exhibit acceptable risk to the bank in terms of financial capacity to repay their loans as well as possessing acceptable fallback repayment sources, typically collateral and personal guarantees. These loans are subject to a formal annual review process; additionally, management reviews the risk rating at the time of any late payments, overdrafts or other sign of deterioration in the interim.


Loans rated Pass-Watch require more than usual attention and monitoring by the account officer, but not to the extent that a formal remediation plan is warranted. Borrowers can be rated Pass-Watch based upon a weakened capital structure, adequate but low cash flow and/or collateral coverage, or early-stage declining trends in operations or financial condition.


Loans rated Special Mention possess potential weakness that may expose the bank to some risk of loss in the future. These loans require more frequent monitoring and formal reporting to management.


Substandard loans reflect well-defined weaknesses in the current repayment capacity, collateral or net worth of the borrower with the possibility of some loss to the bank if these weaknesses are not corrected. Action plans are required for these loans to address the inherent weakness in the credit and are formally reviewed.


Below is a summary of loans by credit quality indicator as of June 30, 2011:


(In thousands)

Unrated
Residential
and
Consumer

Pass

Pass-
Watch

Special
Mention

Sub-
Standard

Total

Commercial, financial and agricultural

$           0

$139,974

$23,028

$   910

$  1,753

$165,665

Municipal

0

37,933

0

0

0

37,933

Real estate – residential

 

 

 

 

 

 

    First mortgage

375,031

0

1,871

702

1,431

379,035

    Second mortgage

39,022

0

0

0

189

39,211

Real estate – commercial

 

 

 

 

 

 

    Owner occupied

0

109,658

15,990

5,016

11,435

142,099

    Non-owner occupied

0

132,488

23,548

1,830

4,382

162,248

Real estate – construction

 

 

 

 

 

 

    Residential

2,005

0

0

0

0

2,005

    Commercial

0

6,809

638

693

158

8,298

Installment

6,319

0

0

0

0

6,319

All other loans

385

0

0

152

0

537

Total

$422,762

$426,862

$65,075

$9,303

$19,348

$943,350




13




Below is a summary of loans by credit quality indicator as of December 31, 2010:


(In thousands)

Unrated
Residential
and
Consumer

Pass

Pass-
Watch

Special
Mention

Sub-
Standard

Total

Commercial, financial and agricultural

$           0

$103,384

$  5,271

$  2,038

$  1,821

$112,514

Municipal

0

67,861

0

0

0

67,861

Real estate – residential

 

 

 

 

 

 

    First mortgage

380,712

0

0

0

0

380,712

    Second mortgage

42,269

0

0

0

0

42,269

Real estate – commercial

 

 

 

 

 

 

    Owner occupied

0

95,705

14,732

4,601

10,918

125,956

    Non-owner occupied

0

120,491

26,735

4,604

6,510

158,340

Real estate – construction

 

 

 

 

 

 

    Residential

0

3,568

1,562

1,157

0

6,287

    Commercial

0

9,015

186

629

303

10,133

Installment

6,284

0

0

0

0

6,284

All other loans

270

0

0

168

0

438

Total

$429,535

$400,024

$48,486

$13,197

$19,552

$910,794


The amount of interest which was not earned, but which would have been earned had our nonaccrual and restructured loans performed in accordance with their original terms and conditions, was approximately $108 thousand for the six months ended June 30, 2011.


It is our policy 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.


Note 4: Fair Value of Financial Instruments


We apply the provisions of Financial Accounting Standards Board (“FASB”) Accounting Standards Codification Topic 820 (“ASC 820”), “Fair Value Measurements,” for fair value measurement of financial assets and financial liabilities and for fair value measurements of nonfinancial items that are recognized or disclosed at fair value in the financial statements on a nonrecurring basis. ASC 820 clarifies that fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. Under ASC 820, fair value measurements are not adjusted for transaction costs. ASC 820 establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurement) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy under ASC 820 are described below:


>

Level 1 - Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.

>

Level 2 - Quoted prices for similar assets or liabilities in active markets, quoted prices in markets that are not active, or inputs that are observable, either directly or indirectly, for substantially the full term of the asset or liability.

>

Level 3 - Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported by little or no market activity).


A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.




14




The table below presents the balance of financial assets and liabilities at June 30, 2011 and December 31, 2010 measured at fair value on a recurring basis:


 

 

 

Fair Value Measurements at Reporting Date Using

(In thousands)

Total

Quoted Prices in
Active Markets
for Identical
Assets
(Level 1)

Significant
Other
Observable
Inputs
(Level 2)

Significant
Unobservable
Inputs
(Level 3)

As of June 30, 2011

U.S. Treasury Obligations

$       250 

$0

$       250 

$0

U.S. Agency Obligations

88,410 

0

88,410 

0

FHLB Obligations

12,149 

0

12,149 

0

Agency MBSs

183,535 

0

183,535 

0

Agency CMOs

113,680 

0

113,680 

0

Non-Agency CMOs

5,505 

0

5,505 

0

ABSs

1,350 

0

1,350 

0

Interest rate swaps

(1,209)

0

(1,209)

0

Total

$403,670 

$0

$403,670 

$0

As of December 31, 2010

U.S. Treasury Obligations

$       250 

$0

$       250 

$0

U.S. Agency Obligations

47,788 

0

47,788 

0

FHLB Obligations

11,457 

0

11,457 

0

Agency MBSs

174,907 

0

174,907 

0

Agency CMOs

224,268 

0

224,268 

0

Non-Agency CMOs

5,852 

0

5,852 

0

ABSs

1,440 

0

1,440 

0

Interest rate swaps

(1,218)

0

(1,218)

0

Total

$464,744 

$0

$464,744 

$0


Investment securities are reported at fair value utilizing Level 2 inputs. The prices for these instruments are obtained through an independent pricing service or dealer market participant with which we have historically transacted both purchases and sales of investment securities. Prices obtained from these sources include market quotations and matrix pricing. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things.


Certain assets are also measured at fair value on a non-recurring basis. These other financial assets include impaired loans and OREO. The table below presents the balance of financial assets at June 30, 2011 measured at fair value on a nonrecurring basis:


 

 

Fair Value Measurements at Reporting Date Using

(In thousands)

Total

Quoted Prices in
Active Markets for
Identical Assets
(Level 1)

Significant Other
Observable
Inputs
(Level 2)

Significant
Unobservable
Inputs
(Level 3)

OREO

$       0

$0

$0

$       0

Impaired loans

3,444

0

0

3,444

        Total

$3,444

$0

$0

$3,444




15




Presented below is a roll forward of assets measured at fair value using significant unobservable inputs (Level 3) as of June 30, 2011:


 

Impaired loans

 

OREO

 

 

(In thousands)

Commercial,
financial and
agricultural

Real estate -
commercial

Real estate -
residential

Real estate -
construction

Installment

 

Real estate -
commercial

 

Total

Beginning Balance

$595 

$2,665 

$844 

$    0

$0

 

$191 

 

$4,295 

Transfers into
 Level 3

155 

136 

350 

158

3

 

 

802 

Transfers out of
 Level 3

(233)

(127)

0

0

 

 

(360)

Payments

(235)

(360)

(411)

0

0

 

 

(1,006)

Sale

0

0

 

(224)

 

(224)

Charge-offs

(88)

(8)

0

0

 

 

(96)

Settlements/expense
 recoveries

0

0

 

33 

 

33 

Ending Balance

$427 

$2,200 

$656 

$158

$3

 

$    0 

 

$3,444 


Transfers into Level 3 represent loans that have been placed on non-accruing status. Transfers out of Level 3 represent loans that are either no longer past due greater than 90 days or more, or have been returned to accruing status.


In accordance with the provisions of FASB ASC Subtopic 310-10-35, “Accounting by Creditors for Impairment of a Loan – an amendment of FASB Statements No. 5 and 15,” we had collateral dependent impaired loans with a carrying value of approximately $1.04 million, which had specific reserves included in the allowance for loan losses of $209 thousand at June 30, 2011.


We use the fair value of underlying collateral to estimate the specific reserves for collateral dependent impaired loans. Collateral may be real estate and/or business assets including equipment, inventory and accounts receivable. Real estate values are determined based on appraisals by qualified licensed appraisers we have hired. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Management’s ongoing review of appraisal information may result in additional discounts or adjustments to valuation based upon more recent market sales activity or more current appraisal information derived from properties of similar type and/or locale. Other business assets are valued using a variety of approaches including appraisals, depreciated book value, purchase price and independent confirmation of accounts receivable. OREO in the table above consists of property acquired through foreclosures and settlements of loans. Property acquired is carried at the lower of cost or the estimated fair value of the property, determined by an independent appraisal, and is adjusted for estimated disposal costs. Because of the significant amount of judgment involved in valuing both collateral dependent impaired loans and OREO these assets are classified as Level 3 in the fair value hierarchy.


FASB ASC Subtopic 820-10-50, “Disclosures about Fair Value of Financial Instruments,” as amended, requires disclosure of the fair value of financial assets and financial liabilities, including those financial assets and financial liabilities that are not measured and reported at fair value on a recurring or nonrecurring basis. The methodologies for estimating the fair value of financial assets and financial liabilities that are measured at fair value on a recurring or non-recurring basis are discussed above. The carrying amounts reported in the consolidated balance sheets for cash and cash equivalents and the FHLB stock approximate fair value. The methodologies for other financial assets and financial liabilities are discussed below.


Loans - The fair value for loans is estimated using discounted cash flow analyses, using interest rates and spreads currently being offered for loans with similar terms to borrowers of similar credit quality. The fair value estimates, methods and assumptions set forth below for our financial instruments, including those financial instruments carried at cost, are made solely to comply with disclosures required by generally accepted accounting principles in the United States and do not always incorporate the exit-price concept of fair value proscribed by ASC 820-10 and should be read in conjunction with the financial statements and associated footnotes.


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 method which applies interest rates currently being offered for deposits of similar remaining maturities.




16




Debt - The fair value of debt is estimated using current market rates for borrowings of similar remaining maturity.


Interest rate swap - The interest rate swaps are reported at their fair value of $(1.21) million and $(1.22) million as of June 30, 2011 and December 31, 2010, respectively, utilizing Level 2 inputs from third parties. The fair value of our interest rate swaps are determined using prices obtained from a third party advisor. The fair value measurement of the interest rate swap is determined by netting the discounted future fixed cash payments and the discounted expected variable cash receipts. The variable cash receipts are based on the expectation of future interest rates derived from observed market interest rate curves.


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 was approximately $51 thousand and $40 thousand as of June 30, 2011 and December 31, 2010, respectively.


The fair value of our financial instruments as of June 30, 2011 and December 31, 2010 are summarized in the table below:


 

June 30, 2011

 

December 31, 2010

(In thousands)

Carrying
Amount

Fair Value

 

Carrying
Amount

Fair Value

Securities available for sale

$   404,879

$   404,879

 

$   465,962

$   465,962

Securities held to maturity

651

725

 

794

882

FHLB stock

8,630

8,630

 

8,630

8,630

Loans, net of the allowance for loan losses

932,912

949,916

 

900,659

913,882

Accrued interest receivable

4,578

4,578

 

4,992

4,992

    Total assets

$1,351,650

$1,368,728

 

$1,381,037

$1,394,348

 

 

 

 

 

 

Deposits

$1,103,098

$1,105,856

 

$1,092,196

$1,094,455

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

155,208

155,341

 

227,657

228,109

Securities sold under agreement to repurchase and other
 long-term borrowings

38,600

39,663

 

38,639

39,574

Junior subordinated debentures issued to unconsolidated
 subsidiary trust

20,619

13,999

 

20,619

14,413

Accrued interest payable

340

340

 

377

377

    Total liabilities

$1,317,865

$1,315,199

 

$1,379,488

$1,376,928


Note 5: Pension


We formerly had a noncontributory defined benefit pension plan (the “Plan”) covering all eligible employees. The Plan was a final average pay plan with benefits based on the average salary rates using the five consecutive Plan years of the last ten years that produce the highest average salary. The Plan was curtailed in 1995; all accrued benefits were fully vested and no additional years of service or age will be accrued.


The following table summarizes the components of net periodic benefit costs for the periods indicated:


 

Three Months Ended
June 30,

Six Months Ended
June 30,

(In thousands)

2011

2010

2011

2010

Interest Cost

$ 122 

$ 122 

$ 244 

$ 241 

Service cost

14 

16 

28 

27 

Expected return on Plan assets

(156)

(154)

(312)

(300)

Amortization of net loss

70 

46 

140 

121 

Net periodic benefit cost

$   50 

$   30 

$ 100 

$   89 




17




We do not expect to make a contribution to the pension plan during 2011.


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


Note 6: Earnings Per Share


The following table presents reconciliations of the calculations of basic and diluted earnings per common share for the periods indicated:


 

Three Months Ended
June 30,

Six Months Ended
June 30,

(In thousands except per share data)

2011

2010

2011

2010

Net income

$3,629

$4,586

$6,730

$8,415

Weighted average common shares outstanding

6,206

6,162

6,199

6,157

Dilutive effect of common stock equivalents

10

0

11

0

Weighted average common and common equivalent
 shares outstanding

6,216

6,162

6,210

6,157

Basic earnings per common share

$  0.58

$  0.74

$  1.09

$  1.37

Diluted earnings per common share

$  0.58

$  0.74

$  1.08

$  1.37


Basic earnings per common share were computed by dividing net income by the weighted average number of shares of common stock outstanding for the three and six months ended June 30, 2011 and 2010. For the three and six months ended June 30, 2011 and 2010, there were average stock options outstanding of 10,000, which were not considered in the calculation of diluted earnings per share because the stock options’ exercise price was greater than the average market price during these periods.


Note 7: Stock Repurchase Program


We extended, through January 2012, our stock buyback program, originally adopted in January 2007. Under the program we may repurchase up to 200,000 shares of our common stock on the open market from time to time, and have purchased 143,475 shares at an average price per share of $22.94 since the program’s adoption. We did not repurchase any of our shares during 2010 or during the first half of 2011, and do not expect to repurchase shares in the near future.


Note 8: Commitments and Contingencies


We are a party to financial instruments with off balance sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments 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.


We do not issue any guarantees that would require liability recognition or disclosure, other than our standby letters of credit. Standby letters of credit are conditional commitments issued by us to 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 $5.12 million at June 30, 2011 and represent the maximum potential future payments we 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 for on-balance sheet instruments. Our 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 our standby letters of credit at June 30, 2011 was insignificant.


We are involved in routine legal proceedings that occur in the ordinary course of business, which, individually and in the aggregate, are believed by Management to be immaterial to our financial condition and results of operations.




18




Note 9: Recent Accounting Pronouncements


In June 2011, the FASB issued ASU 2011-05, “Comprehensive Income (Topic 220): Presentation of Comprehensive Income.” The main provisions of ASU 2011-05 require that all non-owner changes in stockholders’ equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both choices, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. ASU 2011-05 is effective retrospectively for fiscal years, and interim periods within those years, beginning after December 15, 2011. We are assessing the impact of ASU 2011-05 on our comprehensive income presentation.


In May 2011, the FASB issued ASU 2011-04, “Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.” The amendments in this Update change the wording used to describe the requirements in U.S. GAAP for measuring fair value and for disclosing information about fair value measurements. The amendments clarify the Board’s intent about the application of existing fair value measurement and disclosure requirements. The amendments in this Update are to be applied prospectively. For public entities, the amendments are effective during interim and annual periods beginning after December 15, 2011. We do not expect that this guidance will have a material impact on our financial condition or results of operations.


In April 2011, the FASB issued ASU No. 2011-03 “Transfers and Servicing (Topic 860) - Reconsideration of Effective Control for Repurchase Agreement.” ASU 2011-03 removes from the assessment of effective control the criterion relating to the transferor’s ability to repurchase or redeem financial assets on substantially the agreed terms, even in the event of default by the transferee. ASU 2011-03 is effective for the first interim or annual period beginning on or after December 15, 2011. The guidance should be applied prospectively to transactions or modifications of existing transactions that occur on or after the effective date. Early adoption is not permitted. We are assessing the impact of ASU 2011-03 on our financial condition, results of operations, and disclosures.


In January 2011, the FASB issued ASU 2011-01, “Receivables (Topic 310) – Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Updated No. 2010-20” and in April 2011 issued ASU 2011-02, “Receivables (Topic 310) – A Creditors Determination of Whether a Restructuring is a Troubled Debt Restructuring.” The main provisions in this Update indicate that a creditor must separately conclude, in evaluating whether a restructuring constitutes a TDR, that both of the following exist: the restructuring constitutes a concession and the debtor is experiencing financial difficulties. The amendments to Topic 310 clarify the guidance on a creditor’s evaluation of whether it has granted a concession, and whether a debtor is experiencing financial difficulties. This ASU also clarifies that a creditor is precluded from using the effective interest rate test when evaluating whether a restructuring constitutes a TDR. The amendments are effective for the first interim period beginning on or after June 15, 2011 and should be applied retrospectively to the beginning of the annual period of adoption. We do not expect that this guidance will have a material impact on our financial condition or results of operations.


In July 2010, the FASB issued ASU 2010-20, “Receivables (Topic 310) – Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses.” The main objective in developing this updated guidance is to provide financial statement users with greater transparency about an entity’s allowance for credit losses and the credit quality of its financing receivables. This updated guidance requires additional information to assist financial statement users in assessing an entity’s credit risk exposures and evaluating the adequacy of its allowance for credit losses. We have determined that this guidance will not have a material impact on our financial condition or results of operations.


Item 2.  Management's Discussion and Analysis of Financial Condition and Results of Operations


Forward Looking Statements

Certain statements contained in this Quarterly Report on Form 10-Q that are not historical facts may constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and are intended to be covered by the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements involve risks and uncertainties. These statements, which are based on certain assumptions and describe our future plans, strategies and expectations, can generally be identified by the use of the words “may,” “will,” “should,” “could,” “would,” “plan,” “potential,” “estimate,” “project,” “believe,” “intend,” “anticipate,” “expect,” “target” and similar expressions. Forward-looking statements are based on the current assumptions and beliefs of management and are only expectations of future results. Our actual results could differ materially from those projected in the forward-looking statements as a result of, among others, general, national, regional or local economic conditions which are less favorable than anticipated, including continued global recession, impacting the performance of our investment portfolio, quality of credits or the overall demand for services; changes in loan default and charge-off rates which could affect the allowance for credit losses; declines in the equity and financial markets; reductions in deposit levels which could necessitate increased and/or higher cost borrowing to fund loans and investments; declines in




19




mortgage loan refinancing, equity loan and line of credit activity which could reduce net interest and noninterest income; changes in the domestic interest rate environment and inflation; changes in the carrying value of investment securities and other assets; further actions by the U.S. government and Treasury Department that could have a negative impact on our investment portfolio and earnings; misalignment of our interest-bearing assets and liabilities; increases in loan repayment rates affecting interest income; changing business, banking, or regulatory conditions or policies, or new legislation affecting the financial services industry, such as the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, that could lead to changes in the competitive balance among financial institutions, restrictions on bank activities, changes in costs (including deposit insurance premiums), increased regulatory scrutiny, declines in consumer confidence in depository institutions, or changes in the secondary market for bank loan and other products; and changes in accounting rules, federal and state laws, IRS regulations, and other regulations and policies governing financial holding companies and their subsidiaries which may impact our ability to take appropriate action to protect our financial interests in certain loan situations.


Investors should not place undue reliance on our forward-looking statements, and 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, which are included in more detail in our Annual Report on Form 10-K, as updated by our Quarterly Reports on Form 10-Q, and other filings submitted to the Securities and Exchange Commission. We do not undertake any obligation to update any forward-looking statement to reflect circumstances or events that occur after the date the forward-looking statements are made.


Use of Non-GAAP Financial Measures

Certain information in Management’s Discussion and Analysis of Financial Condition and Results of Operations and elsewhere in this Report contains financial information determined by methods other than in accordance with accounting principles generally accepted in the United States of America (“GAAP”). We use these “non-GAAP” measures in our analysis of our performance and believe that these non-GAAP financial measures provide a greater understanding of ongoing operations and enhance comparability of results with prior periods as well as demonstrating the effects of significant gains and charges in the current period. We believe that a meaningful analysis of our financial performance requires an understanding of the factors underlying that performance. We believe that investors may use these non-GAAP financial measures to analyze financial performance without the impact of unusual items that may obscure trends in our underlying performance. These disclosures should not be viewed as a substitute for operating results determined in accordance with GAAP, nor are they necessarily comparable to non-GAAP performance measures that may be presented by other companies.


In several places net interest income is presented on a fully taxable equivalent basis. Specifically included in interest income was tax-exempt interest income from certain tax-exempt loans. An amount equal to the tax benefit derived from this tax exempt income is added back to the interest income total, to produce net interest income on a fully taxable equivalent basis. We believe the disclosure of tax-equivalent net interest income information improves the clarity of financial analysis, and is particularly useful to investors in understanding and evaluating the changes and trends in our results of operations. Other financial institutions commonly present net interest income on a tax-equivalent basis. This adjustment is considered helpful in the comparison of one financial institution’s net interest income to that of another, as each will have a different proportion of tax-exempt interest from its earning assets. Moreover, net interest income is a component of a second financial measure commonly used by financial institutions, net interest margin, which is the ratio of net interest income to average earning assets. For purposes of this measure as well, other financial institutions generally use tax-equivalent net interest income to provide a better basis of comparison from institution to institution. We follow these practices. A reconciliation of tax-equivalent financial information to our consolidated financial statements prepared in accordance with GAAP appears at the bottom of the table entitled “Average Balance Sheets and Average Rates.” A 35.0% tax rate was used in both 2011 and 2010.


General

All adjustments necessary for a fair presentation of our interim consolidated financial statements as of June 30, 2011, and for the three and six months ended June 30, 2011 and 2010 have been included. The information was prepared from our unaudited financial statements and financial statements of our subsidiaries, Merchants Bank and MBVT Statutory Trust I.


Results of Operations


Overview

Net income was $3.63 million and $6.73 million for the quarter and six months ended June 30, 2011, respectively, compared to $4.59 million and $8.42 million for the same periods in 2010. The return on average assets was 0.98% and 0.91% for the quarter and six months ended June 30, 2011, respectively, compared to 1.29% and 1.19% for the same periods in 2010. The return on average equity was 14.20% and 13.38% for the quarter and six months ended June 30, 2011, respectively, compared to 19.48% and 18.10% for the same periods in 2010.




20





The following were the major factors contributing to our results for the quarter and six months ended June 30, 2011 compared to the same periods in 2010:


Net interest income on a fully taxable equivalent (“FTE”) basis was $52 thousand higher for the second quarter of 2011 compared to the same period in 2010, and was $205 thousand lower for the first six months of 2011 compared to 2010;


We recorded a $250 thousand provision for credit losses during the second quarter of 2011, compared to no provision in the second quarter of 2010. Our provision for credit losses for the first six months of 2011 was $250 thousand compared to $600 thousand for the first six months of 2010;


We recognized $137 thousand and $127 thousand in pre-tax security gains for the quarter and six months ended June 30, 2011, respectively, compared to $503 thousand and $1.21 million for the same periods in 2010;


Service charges on deposits were $1.07 million and $2.03 million for the quarter and six months ended June 30, 2011, respectively, a decrease of $323 thousand and $600 thousand compared to the same periods in 2010. This decrease is a result of reduced overdraft fee income resulting from legislative changes that went into effect August 15, 2010.


We booked net expense recoveries and gains on the sale of OREO property during the second quarter and first six months of 2010 totaling $(196) thousand and $(390) thousand, respectively, compared to expenses of $65 thousand and $81 thousand for the same periods in 2011.


Loans ended the quarter at $943.35 million, a $32.56 million increase over year end balances of $910.79 million.


Total deposits ended the quarter at $1.10 billion, an increase of $10.90 million over year end deposit balances.


Net Interest Income

This discussion should be read in conjunction with the tables on the following three pages. Our taxable equivalent net interest income was $12.95 million and $25.11 million for the quarter and six months ended June 30, 2011, respectively, compared to $12.90 million and $25.32 million for the same periods in 2010. Our taxable equivalent net interest margin decreased 19 basis points to 3.62% for the second quarter of 2011 compared to 3.81% for the same period in 2010, and decreased 24 basis points to 3.53% for the six months ended June 30, 2011 compared to 3.77% for the same period in 2010. The margin for the second quarter of 2011 increased by 25 basis points when compared to the fourth quarter of 2010, and increased 17 basis points from the first quarter of 2011.


The average rate on interest earning assets has increased gradually over the last two quarters as a result of two factors. We have moved a larger portion of our interest earning asset base into higher yielding loans and out of cash and investments, and the average yield on our investment portfolio has increased as overall prepayment speeds on mortgage backed investments have slowed. Average loans increased to $944.81 million for the second quarter of 2011 compared to $916.38 million for the first quarter of 2011, and $905.05 million for the fourth quarter of 2010. The impact of this reallocation to loans has been muted by the fact that the average yield on our loan portfolio has continued to decrease incrementally over the last several quarters as overall interest rates have remained at historic lows for an extended period of time. Average investments have decreased to $452.31 million for the second quarter of 2011 compared to $469.92 million for the first quarter of 2011 and $483.68 million for the fourth quarter of 2010. Average yields on the investment portfolio have increased over the last three quarters from 2.48% for the fourth quarter of 2010 to 2.61% for the first quarter of 2011 and to 3.11% for the second quarter of 2011. Although interest rates remain very low and cash flows off our investment portfolio have slowed considerably, this has helped our average yield in two ways. First, we have less cash to put to work at current low rates. Second, for bonds purchased at a premium, the slow down in cash flow also reduces the premium amortization, which increases the yield on the bond.


We continued to reduce our average cost of interest-bearing liabilities during the second quarter of 2011. The average cost of interest-bearing liabilities decreased to 0.73% for the second quarter of 2011 compared to 0.76% for the first quarter of 2011 and 0.83% for the fourth quarter of 2010. We prepaid a total of $46.50 million in long-term securities sold under agreements to repurchase at an average rate of 3.74% during the fourth quarter of 2010, which has contributed to the reduction in the cost of borrowed funds.




21




The following table attributes changes in our net interest income (on a fully taxable equivalent basis) to changes in either average balances or average rates for the six months ended June 30, 2011. Changes due to both interest rate and volume have been allocated to change due to volume and change due to rate in proportion to the relationship of the absolute dollar amounts of the change in each category:


 

Three Months Ended

 

Due to

(In thousands)

June 30,
2011

June 30,
2010

Increase
(Decrease)

Volume

Rate

Fully taxable equivalent interest income:

 

 

 

 

 

Loans

$11,647

$11,856

$(209)

$   427 

$   (636)

Investments

3,507

3,831

(324)

319 

(643)

Interest earning deposits with banks and other
 short-term investments

14

24

(10)

11 

(21)

        Total interest income

15,168

15,711

(543)

757 

(1,300)

Less interest expense:

 

 

 

 

 

Savings, money market and NOW accounts

292

369

(77)

27 

(104)

Time deposits

840

1,053

(213)

(41)

(172)

FHLB and other short-term borrowings

1

1

Securities sold under agreements to repurchase,
 short-term

515

380

135 

104 

31 

Securities sold under agreement to repurchase,
 long term

56

495

(439)

(359)

(80)

Other long-term debt

214

215

(1)

(1)

Junior subordinated debentures issued to
 unconsolidated subsidiary trust

301

301

        Total interest expense

2,219

2,814

(595)

(269)

(326)

        Net interest income

$12,949

$12,897

$   52 

$1,026 

$   (974)


 

Six Months Ended

 

Due to

(In thousands)

June 30,
2011

June 30,
2010

Increase
(Decrease)

Volume

Rate

Fully taxable equivalent interest income:

 

 

 

 

 

Loans

$23,055

$23,501

$   (446)

$   441 

$   (887)

Investments

6,530

7,553

(1,023)

770 

(1,793)

Interest earning deposits with banks and other
 short-term investments

44

45

(1)

27 

(28)

        Total interest income

29,629

31,099

(1,470)

1,238 

(2,708)

Less interest expense:

 

 

 

 

 

Savings, money market and NOW accounts

616

758

(142)

69 

(211)

Time deposits

1,717

2,228

(511)

(102)

(409)

FHLB and other short-term borrowings

1

2

(1)

(1)

Securities sold under agreements to repurchase,
 short-term

1,052

788

264 

228 

36 

Securities sold under agreement to repurchase,
 long term

111

984

(873)

(715)

(158)

Other long-term debt

427

429

(2)

(2)

Junior subordinated debentures issued to
 unconsolidated subsidiary trust

594

594

        Total interest expense

4,518

5,783

(1,265)

(520)

(745)

        Net interest income

$25,111

$25,316

$   (205)

$1,758 

$(1,963)




22




The following tables set forth certain information regarding net interest margin for the three and six months ended June 30, 2011 and 2010. For the periods indicated, the total dollar amount of interest income from average earning assets and the resultant yields, as well as the interest expense on average interest bearing liabilities, are expressed both in dollars and rates, and on a taxable equivalent basis.


Merchants Bancshares, Inc.

Average Balance Sheets and Average Rates

(Unaudited)


 

Three Months Ended

 

June 30, 2011

 

June 30, 2010

(In thousands, fully taxable equivalent)

Average
Balance

 

Interest
Income/
Expense

 

Average
Rate

 

Average
Balance

 

Interest
Income/
Expense

 

Average
Rate

ASSETS:

 

 

 

 

 

 

 

 

 

 

 

Loans, including fees on loans (a)(c)

$   944,813 

 

$11,647 

 

4.94%

 

$   911,211 

 

$11,856 

 

5.22%

Investments (b)

452,309 

 

3,507 

 

3.11%

 

423,994 

 

3,831 

 

3.62%

Interest-earning deposits with banks and other
  short-term investments

37,005 

 

14 

 

0.16%

 

22,188 

 

24 

 

0.43%

        Total interest earning assets

1,434,127 

 

$15,168 

 

4.24%

 

1,357,393 

 

$15,711 

 

4.64%

Allowance for loan losses

(10,329)

 

 

 

 

 

(10,132)

 

 

 

 

Cash and cash equivalents

11,696 

 

 

 

 

 

25,298 

 

 

 

 

Bank premises and equipment, net

14,201 

 

 

 

 

 

13,350 

 

 

 

 

Other assets

31,938 

 

 

 

 

 

32,686 

 

 

 

 

        Total assets

$1,481,633 

 

 

 

 

 

$1,418,595 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

LIABILITIES AND SHAREHOLDERS'
 EQUITY:

 

 

 

 

 

 

 

 

 

 

 

Interest-bearing deposits:

 

 

 

 

 

 

 

 

 

 

 

    Savings, NOW & money market accounts

$   588,759 

 

$     292 

 

0.20%

 

$   545,784 

 

$     369 

 

0.27%

    Time deposits

360,895 

 

840 

 

0.93%

 

375,557 

 

1,053 

 

1.12%

        Total interest bearing deposits

949,654 

 

1,132 

 

0.48%

 

921,341 

 

1,422 

 

0.62%

FHLB and other short-term borrowings

3,434 

 

 

0.12%

 

2,674 

 

 

0.08%

Securities sold under agreements to repurchase,
 short-term

206,796 

 

515 

 

1.00%

 

160,688 

 

380 

 

0.95%

Securities sold under agreements to repurchase,
 long-term

7,500 

 

56 

 

2.97%

 

54,000 

 

495 

 

3.68%

Other long-term debt

31,108 

 

214 

 

2.77%

 

31,203 

 

215 

 

2.77%

Junior subordinated debentures issued to
 unconsolidated subsidiary trust

20,619 

 

301 

 

5.85%

 

20,619 

 

301 

 

5.86%

        Total borrowed funds

269,457 

 

1,087 

 

1.62%

 

269,184 

 

1,392 

 

2.07%

        Total interest bearing liabilities

1,219,111 

 

$  2,219 

 

0.73%

 

1,190,525 

 

$  2,814 

 

0.95%

Noninterest bearing deposits

149,522 

 

 

 

 

 

122,472 

 

 

 

 

Other liabilities

10,748 

 

 

 

 

 

11,425 

 

 

 

 

Shareholders' equity

102,252 

 

 

 

 

 

94,173 

 

 

 

 

        Total liabilities and shareholders' equity

$1,481,633 

 

 

 

 

 

$1,418,595 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net interest earning assets

$   215,016 

 

 

 

 

 

$   166,868 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net interest income (fully taxable equivalent)

 

 

$12,949 

 

 

 

 

 

$12,897 

 

 

Tax equivalent adjustment

 

 

(457)

 

 

 

 

 

(254)

 

 

Net interest income

 

 

$12,492 

 

 

 

 

 

$12,643 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net interest rate spread

 

 

 

 

3.51%

 

 

 

 

 

3.69%

 

 

 

 

 

 

 

 

 

 

 

 

Net interest margin

 

 

 

 

3.62%

 

 

 

 

 

3.81%


(a)

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

(b)

Available for sale securities and held to maturity securities are included at amortized cost. Includes FHLB stock.

(c)

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




23




Merchants Bancshares, Inc.

Average Balance Sheets and Average Rates

(Unaudited)


 

Six Months Ended

 

June 30, 2011

 

June 30, 2010

(In thousands, fully taxable equivalent)

Average
Balance

 

Interest
Income/
Expense

 

Average
Rate

 

Average
Balance

 

Interest
Income/
Expense

 

Average
Rate

ASSETS:

 

 

 

 

 

 

 

 

 

 

 

Loans, including fees on loans (a)(c)

$   930,677 

 

$23,055 

 

5.00%

 

$   913,378 

 

$23,501 

 

5.19%

Investments (b)

460,990 

 

6,530 

 

2.86%

 

419,473 

 

7,553 

 

3.63%

Interest-earning deposits with banks and other
  short-term investments

40,889 

 

44 

 

0.22%

 

21,134 

 

45 

 

0.42%

        Total interest earning assets

1,432,556 

 

$29,629 

 

4.17%

 

1,353,985 

 

$31,099 

 

4.63%

Allowance for loan losses

(10,294)

 

 

 

 

 

(10,650)

 

 

 

 

Cash and cash equivalents

12,990 

 

 

 

 

 

25,455 

 

 

 

 

Bank premises and equipment, net

14,263 

 

 

 

 

 

13,310 

 

 

 

 

Other assets

31,601 

 

 

 

 

 

32,234 

 

 

 

 

        Total assets

$1,481,116 

 

 

 

 

 

$1,414,334 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

LIABILITIES AND SHAREHOLDERS'
 EQUITY:

 

 

 

 

 

 

 

 

 

 

 

Interest-bearing deposits:

 

 

 

 

 

 

 

 

 

 

 

    Savings, NOW & money market accounts

$   586,968 

 

$     616 

 

0.21%

 

$   534,663 

 

$     758 

 

0.29%

    Time deposits

363,366 

 

1,717 

 

0.95%

 

381,443 

 

2,228 

 

1.18%

        Total interest bearing deposits

950,334 

 

2,333 

 

0.49%

 

916,106 

 

2,986 

 

0.66%

FHLB and other short-term borrowings

2,618 

 

 

0.08%

 

2,862 

 

 

0.14%

Securities sold under agreements to repurchase,
 short-term

212,574 

 

1,052 

 

1.00%

 

163,658 

 

788 

 

0.97%

Securities sold under agreements to repurchase,
 long-term

7,500 

 

111 

 

2.98%

 

54,000 

 

984 

 

3.67%

Other long-term debt

31,117 

 

427 

 

2.77%

 

31,203 

 

429 

 

2.77%

Junior subordinated debentures issued to
 unconsolidated subsidiary trust

20,619 

 

594 

 

5.81%

 

20,619 

 

594 

 

5.81%

        Total borrowed funds

274,428 

 

2,185 

 

1.61%

 

272,342 

 

2,797 

 

2.07%

        Total interest bearing liabilities

1,224,762 

 

$  4,518 

 

0.74%

 

1,188,448 

 

$  5,783 

 

0.98%

Noninterest bearing deposits

144,623 

 

 

 

 

 

120,433 

 

 

 

 

Other liabilities

11,142 

 

 

 

 

 

12,447 

 

 

 

 

Shareholders' equity

100,589 

 

 

 

 

 

93,006 

 

 

 

 

        Total liabilities and shareholders' equity

$1,481,116 

 

 

 

 

 

$1,414,334 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net interest earning assets

$   207,794 

 

 

 

 

 

$   165,538 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net interest income (fully taxable equivalent)

 

 

$25,111 

 

 

 

 

 

$25,316 

 

 

Tax equivalent adjustment

 

 

(866)

 

 

 

 

 

(410)

 

 

Net interest income

 

 

$24,245 

 

 

 

 

 

$24,906 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net interest rate spread

 

 

 

 

3.43%

 

 

 

 

 

3.65%

 

 

 

 

 

 

 

 

 

 

 

 

Net interest margin

 

 

 

 

3.53%

 

 

 

 

 

3.77%


(a)

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

(b)

Available for sale securities and held to maturity securities are included at amortized cost. Includes FHLB stock.

(c)

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




24




Provision for Credit Losses (“Provision”): We recorded a $250 thousand provision for credit losses for the quarter and six months ended June 30, 2011, respectively, compared to $0 and $600 thousand for the quarter and six months ended June 30, 2010, respectively. Although asset quality remains high, our strong loan growth during the second quarter of 2011 led to the need for a provision during the quarter. Our non-performing asset totals decreased to $3.44 million at June 30, 2011, compared to $3.91 million at March 31, 2011, $4.30 million at December 31, 2010 and $8.78 million at June 30, 2010. Additionally, accruing substandard loans decreased to $17.01 million at June 30, 2011 from $18.07 million at December 31, 2010 and $19.33 million at June 30, 2010. Approximately $315 thousand in non-accruing loans carry some form of government guarantee. All of these factors are taken into consideration during management’s quarterly review of the allowance for credit losses which we continue to deem reasonable at June 30, 2011. See “Credit Quality and the Allowance for Credit Losses” for additional information on the provision, the allowance for credit losses and the allowance for loan losses.


Noninterest Income: Total noninterest income decreased to $2.56 million and $4.65 million for the quarter and six months ended June 30, 2011, respectively, compared to $3.16 million and $6.06 million for the same periods in 2010. Excluding net gains (losses) on security sales and other than temporary impairment losses, noninterest income decreased $229 thousand to $2.42 million for the second quarter of 2011 compared to $2.65 million for the same period in 2010 and decreased $407 thousand to $4.53 million for the first six months of 2011 compared to the first six months of 2010. This decrease is primarily a result of reductions in overdraft fee revenue attributable to legislative changes that went into effect on August 15, 2010. Net overdraft fee revenue was $855 thousand and $1.61 million for the quarter and six months ended June 30, 2011, compared to $1.17 million and $2.20 million for the same periods in 2010. Trust division income continued to grow during 2011 and increased to $632 thousand and $1.26 million for the quarter and six months ended June 30, 2011, compared to $533 thousand and $1.05 million for the same periods in 2010. Trust division assets under management have grown to $488.85 million at June 30, 2011 from $460.42 million at December 31, 2010 and $388.24 million at June 30, 2010. Other categories of noninterest income were generally flat compared to 2010.


Noninterest Expense: Total noninterest expense was $10.21 million and $20.32 million for the quarter and six months ended June 30, 2011, respectively, compared to $9.62 million and $19.09 million for the same periods in 2010. There were several factors that combined to produce the changes. Salaries and wages and employee benefits were slightly higher for the quarter and six months ended June 30, 2011 compared to the same periods in 2010, primarily a result of normal salary increases. Occupancy and Equipment expenses were $1.76 million and $3.59 million for the quarter and six months ended June 30, 2011, respectively, compared to $1.62 million and $3.23 million for the same periods in 2010. This increase is primarily a result of depreciation related to significant bank-wide investments in telecommunication and computer equipment. We believe that these investments will provide us with additional operating efficiencies and cost savings. Legal and professional fees were $774 thousand and $1.38 million for the quarter and six months ended June 30, 2011, respectively, compared to $664 thousand and $1.26 million for the same periods last year. We have hired consultants to help us realize additional operating efficiencies resulting in increased expenses which we expect to recover over time. Additionally, marketing expenses were $445 thousand and $784 thousand for the quarter and six months ended June 30, 2010, respectively, compared to $366 thousand and $681 thousand for the same periods in 2010, a result of continued development of our “Vermont Matters” outreach campaign. FDIC insurance expense for the second quarter of 2011 was $194 thousand compared to $340 thousand for the same period in 2010; a result of the new deposit insurance assessment rules that went into effect on April 1, 2011. We booked expense recoveries and gains related to the sale of OREO properties totaling $318 thousand during the first quarter of 2010. This gain resulted in a negative OREO expense during the quarter and six months ended June 30, 2010 of $(196) thousand and $(390) thousand, respectively, compared to expenses of $65 thousand and $81 thousand for the quarter and six months ended June 30, 2011, respectively.


Balance Sheet Analysis


Quarterly average loans for the second quarter of 2011 were $944.81 million, compared to $916.38 million for the first quarter of 2011 and $905.05 million for the fourth quarter of 2010. Ending loan balances at June 30, 2011 were $943.35 million, compared to $922.13 million at March 31, 2011 and $910.79 million at December 31, 2010. Growth in average monthly loan balances was strong with average monthly loan balances for April 2011 at $931.64 million, increasing to $943.84 million for May, and $958.99 million for June. Growth in commercial loans reflects new customers and expansion of existing relationships combined with increased utilization of credit lines by existing customers. Seasonal fluctuations in municipal cash flows reduced June 30, 2011 loan balances by almost $26 million. Municipal loan balances increased to $82.72 million on July 1, 2011 from $37.93 million on June 30, 2011.




25




The following table summarizes the components of our loan portfolio as of the dates indicated:


(In thousands)

June 30,
2011

March 31,
2011

December 31,
2010

Commercial, financial and agricultural

$165,665

$132,657

$112,514

Municipal loans

37,933

71,012

67,861

Real estate loans – residential

418,246

418,703

422,981

Real estate loans – commercial

304,347

280,547

284,296

Real estate loans – construction

10,303

12,283

16,420

Installment loans

6,319

6,461

6,284

All other loans

537

464

438

Total loans

$943,350

$922,127

$910,794


Total deposits at June 30, 2011 were $1.10 billion, slightly higher than balances at December 31, 2010. Although deposit growth from the end of 2010 to the end of the second quarter of 2011 was minimal, the composition of the deposit base has shifted away from interest bearing deposits and into demand deposits. Demand deposits grew $19.73 million to $161.14 million at June 30, 2011 from $141.41 million at December 31, 2010. Approximately $10 million of that growth is a result of a shift in our retail cash rewards checking product from interest bearing to non-interest bearing. Securities sold under agreement to repurchase (“repos”) decreased by $71.70 million to $160.49 million at June 30, 2011 compared to December 31, 2010, primarily a result of seasonal fluctuations concentrated in municipal cash flows.


Our liquidity position remained strong through the first half of 2011. Our investment portfolio totaled $405.53 million at June 30, 2011, a decrease of $61.23 million from the December 31, 2010 ending balance of $466.76 million. We reduced our exposure to premium write off in the investment portfolio by selling $77.03 million in CMOs for a total net gain of $127 thousand during 2011. Proceeds from the sales have funded our strong loan growth, and have replaced reductions in repo balances. Our investment portfolio at June 30, 2011, including both held-to-maturity and available-for-sale securities, consisted of the following:


(In thousands)

Amortized
Cost

Fair
Value

U.S. Treasury Obligations

$       250

$       250

U.S. Agency Obligations

87,907

88,410

FHLB Obligations

11,826

12,149

Agency MBS

177,199

184,260

Agency CMO

111,472

113,680

Non-agency CMO

5,820

5,505

ABS

1,357

1,350

    Total investments

$395,831

$405,604


Agency MBSs and Agency CMOs consist of pools of residential mortgages which are guaranteed by FNMA, FHLMC, or GNMA with various origination dates and maturities. Non-Agency CMOs and ABSs are tracked individually with updates on the performance of the underlying collateral provided at least quarterly. Additionally, we perform stress testing of individual bonds that experience greater levels of market volatility, with the assistance of an outside investment manager.


The non-Agency CMO portfolio consists of four bonds, two with balances less than $100 thousand and an insignificant unrealized loss. We performed no additional analysis on these bonds. Management has performed analyses on the remaining two bonds. One of the bonds, with a book value of $3.79 million and a fair value of $3.52 million at June 30, 2011, is rated AA by Fitch and Baa3 by Moody’s. Delinquencies have been fairly low and prepayments have led to increased credit support. The bond is backed by a large pool of loans with a 2004 issue date, 60-plus day delinquencies have been moderate and steady over the life of the bond, credit scores are high and loan-to-value ratios (“LTVs”) are low. The second bond has a book value of $1.88 million and a fair value of $1.84 million. This bond is rated CCC by Fitch and A- by S&P. Delinquencies on this bond have generally been fairly low, particularly within our tranche, and prepayments have lead to increased credit support. A relatively small loan pool and high average loan size are mitigated by low 60-plus day delinquencies, high credit scores, low LTVs and a 2005 issue date. Our investment advisor has assisted Management in running various cash flow analyses on the bonds to determine the likelihood of a principal loss in the future. In all cases, the likelihood of a loss in excess of our book value was determined to be remote.




26




The ABS portfolio consists of two bonds, one of which, with a book value of $357 thousand and a current market value of $405 thousand, is in an unrealized gain position and, additionally, carries an Agency guarantee. We have performed no further analysis on this bond. The second bond in the ABS portfolio has insurance backing from Ambac. However, because of Ambac’s uncertain financial status, we place no reliance on the insurance wrap in the impairment analysis. The bond is rated CC by Standard & Poor’s and Caa2 by Moody’s. We previously recorded impairment charges on this bond totaling $122 thousand. The book value of the bond, net of the impairment charges, is $1.00 million, and its current market value is $945 thousand. This is the only bond in our bond portfolio with subprime exposure. Principal payments received on the bond during 2011 totaled $135 thousand. We have performed the same analysis on this bond as on our non-Agency CMOs discussed above and consider its additional impairment temporary.


As a member of the FHLB system, we are required to invest in stock of the FHLBB in an amount determined based on our borrowings from the FHLBB. At June 30, 2011, our investment in FHLBB stock totaled $8.63 million. We received dividend income totaling $6 thousand and $13 thousand during the quarter and six months ended June 30, 2011, respectively.


We do not intend to sell the investment securities that are in an unrealized loss position, and it is unlikely that we will be required to sell the investment securities before recovery of their amortized cost bases, which may be maturity.


On December 15, 2004, we closed our private placement of an aggregate of $20.00 million of trust preferred securities. These hybrid securities qualify as regulatory capital, up to certain regulatory limits. At the same time, the securities 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.


During July 2008, we entered into a three-year forward interest rate swap arrangement for $10 million of our $20 million trust preferred issuance which changed to a floating rate in December 2009. The swap fixed the interest rate at 6.50% for the three-year term of the swap. We entered into a swap for the balance of the trust preferred issuance in March of 2009 and fixed the rate at 5.23% for seven years. Our blended cost of the trust preferred issuance beginning in December 2009 was 5.87% for a five-year average term. The trust preferred securities mature on December 31, 2034, and are redeemable without penalty at our option, subject to prior approval by the Board of Governors of the Federal Reserve System (“FRB”), beginning after five years from issuance.


In the ordinary course of business, we make commitments for possible future extensions of credit. At June 30, 2011, we were obligated to fund $5.12 million of standby letters of credit. No losses are anticipated in connection with these commitments.


Income Taxes

We are taxed on income at the federal level by the Internal Revenue Service. Total income tax expense was $1.60 million for the first half of 2011 compared to $2.87 million for the same period in 2010. Our effective tax rate for the six months ended June 30, 2011 was 19.2%, compared to 25.4% for the same period in 2010. Our statutory tax rate was 35% for all periods. Our lower effective tax rate is attributable to the following factors:


We recognized favorable tax benefits from federal affordable housing tax credits and historic rehabilitation credits of $951 thousand for the first six months of 2011 compared to $826 thousand for the first six months of 2010.


Additionally, we recognized favorable tax benefits from Qualified School Construction Bond tax credits of $256 thousand for the first six months of 2011 compared to $120 thousand for the first six months of 2010.


Our tax exempt income totaled $884 thousand for the first six months of 2011 compared to $418 thousand for the first six months of 2010.


Liquidity and Capital Resources

Our liquidity is monitored by the Asset and Liability Committee (“ALCO”) of our Bank’s Board of Directors, based upon our Bank’s policies. As of June 30, 2011, we could borrow up to $49 million in overnight funds, of which $44 million consists of 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. FHLBB borrowings are secured by residential mortgage loans. The total amount of loans pledged to the FHLB for both short and long-term borrowing arrangements totaled $223.26 million at June 30, 2011. We have additional borrowing capacity with the FHLBB of $109 million as of June 30, 2011. Additionally, we have established a borrowing facility with the FRB which will enable us to borrow at the discount window.




27




We also have the ability to borrow through the use of repurchase agreements, collateralized by Agency MBSs and Agency CMOs, with certain approved counterparties. The carrying value of the securities sold under repurchase agreements was $221.96 million and the market value was $227.30 million at June 30, 2011. We maintain effective control over the securities underlying the agreements. Our investment portfolio, which is managed by the ALCO, has a book value of $405.53 million at June 30, 2011, of which $237.60 million was pledged. The portfolio is a reliable source of cash flow for us. We closely monitor our short term cash position. Any excess funds are either left on deposit at the FRB, or are in a fully insured account with one of our correspondent banks.


FHLBB short-term borrowings mature daily, and there was no outstanding balance at June 30, 2011. The Demand Note Due U.S. Treasury matures daily and bears interest at the federal funds rate less 0.25%. The rate on this borrowing at June 30, 2011 was zero.


The following table provides certain information regarding other short term borrowed funds for the three and six months ended June 30, 2011:


(In thousands)

Three Months
Ended
June 30, 2011

Six Months
Ended
June 30, 2011

FHLB and other short-term borrowings

 

 

    Amount outstanding at end of period

$           0

$           0

    Maximum month-end amount outstanding

0

0

    Average amount outstanding

1,440

724

    Weighted average rate during the period

0.28%

0.28%

    Weighted average rate at period end

0

0

Demand note due U.S. Treasury

 

 

    Amount outstanding at end of period

$    2,214

$    2,214

    Maximum month-end amount outstanding

2,643

2,881

    Average amount outstanding

1,994

1,894

    Weighted average rate during the period

0

0

    Weighted average rate at period-end

0

0

Securities sold under agreement to repurchase, short-term

 

 

    Amount outstanding at end of period

$152,994

$152,994

    Maximum month-end amount outstanding

223,101

223,101

    Average amount outstanding

206,796

212,574

    Weighted average rate during the period

1.00%

0.99%

    Weighted average rate at period end

0.60%

0.60%


We extended, through January 2012, our stock buyback program, originally adopted in January 2007. Under the program, we may repurchase up to 200,000 shares of our common stock on the open market from time to time, and have purchased 143,475 shares at an average price per share of $22.94 since the program’s adoption. We did not repurchase any of our shares during 2010 or the first six months of 2011, and we do not expect to repurchase shares in the near future.


As of June 30, 2011, we exceeded all current applicable regulatory capital requirements. We continue to be considered well capitalized under current applicable regulations. Our tangible equity ratio at June 30, 2011 was 7.32% compared to 6.68% at December 31, 2010. The following table represents our actual capital ratios and capital adequacy requirements as of June 30, 2011.


 

Actual

For Capital Adequacy
Purposes

To Be Well
Capitalized Under
Prompt Corrective
Action Provisions

(In thousands)

Amount

Percent

Amount

Percent

Amount

Percent

Merchants Bancshares, Inc.

 

 

 

 

 

 

    Tier 1 leverage capital

$121,482

8.20%

$59,265

4.00%

N/A

N/A

    Tier 1 risk-based capital

121,482

14.63%

33,208

4.00%

N/A

N/A

    Total risk-based capital

131,866

15.88%

66,417

8.00%

N/A

N/A

    Tangible capital

104,786

7.32%

N/A

N/A

N/A

N/A

Merchants Bank

 

 

 

 

 

 

    Tier 1 leverage capital

$118,371

7.97%

$59,421

4.00%

$74,277

5.00%

    Tier 1 risk-based capital

118,371

14.16%

33,429

4.00%

50,143

6.00%

    Total risk-based capital

128,823

15.41%

66,857

8.00%

83,572

10.00%

    Tangible capital

122,461

8.54%

N/A

N/A

N/A

N/A




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


CREDIT QUALITY AND THE ALLOWANCE FOR CREDIT LOSSES


Credit Quality

Stringent credit quality is a major strategic focus of ours, and Management monitors asset quality on a continuous basis. We cannot assure that problem assets will remain at current levels, particularly in light of current or future economic conditions. The asset balances in this category will be dynamic and subject to change as problem loans are either resolved or moved to nonperforming status based upon current developments and the latest available information.


The following table summarizes our nonperforming assets at the dates indicated:


(In thousands)

June 30,
2011

December 31,
2010

June 30,
2010

Nonaccrual loans

$3,071

$3,317

$8,277

Loans past due 90 days or more and still accruing interest

0

384

0

Troubled debt restructuring (“TDR”)

373

403

57

    Total nonperforming loans (“NPL”)

3,444

4,104

8,334

OREO

0

191

444

    Total nonperforming assets (“NPA”)

$3,444

$4,295

$8,778


Nonperforming assets at June 30, 2011 totaled $3.44 million, a decrease of $851 thousand from balances at December 31, 2010. Loans past due 90 days and still accruing at December 31, 2010 consisted primarily of residential real estate loans, these balances were reduced to zero through a combination of foreclosure and migration into non-accruing status. Of the total $3.44 million in nonperforming loans above, $2.20 million are residential mortgages compared to $2.63 million at December 31, 2010. The reduction in nonperforming residential real estate loans is a result of proactive monitoring and communication with individual borrowers. Our residential first lien mortgage portfolio consists entirely of traditional mortgages which are fully underwritten, using conservative loan-to-value and debt-to-income thresholds. We believe that additional loss exposure on current non-accruing loans is mitigated by a combination of conservatively valued collateral and, where needed, an appropriate reserve allocation.


TDR represent balances where the existing loan was modified by the bank involving a concession in rate, term or payment amount due to the distressed financial condition of the borrower. There were three restructured residential mortgages at June 30, 2011 with balances totaling $373 thousand, compared to four borrowers at December 31, 2010 with balances totaling $403 thousand. All TDRs at June 30, 2011 continue to pay as agreed according to the modified terms and are considered well-secured.


We had no OREO at June 30, 2011.


Excluded from the nonaccrual balances discussed above are our loans that are 30 to 89 days past due, which are not necessarily considered classified or impaired. Accruing loans 30 to 89 days past due as a percentage of total loans as of the periods indicated are presented in the following table:


Quarter Ended:

30-89 Days

June 30, 2011

0.11%

December 31, 2010

0.14%

June 30, 2010

0.26%

December 31, 2009

0.09%


Our residential mortgage loan portfolio continues to perform well, even under the currently stressed economic conditions. Residential loans 30 to 89 days past due at June 30, 2011 totaled 26 basis points as a percentage of residential loans. Total non-current residential loans, including non-accruing mortgages, were 54 basis points of residential loans.


Our policy is to classify a loan 90 days or more past due with respect to principal or interest, as well as any loan where Management does not believe it will collect all principal and interest in accordance with contractual terms, as a nonaccruing loan, unless the ultimate collectability of principal and interest is assured. Income accruals are suspended on all nonaccruing loans, and all previously accrued and uncollected interest is charged against current income. A loan remains in nonaccruing status until the factors which suggest doubtful collectability no longer exist, the loan is liquidated, or 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, we can, and may, initiate foreclosure proceedings. The result of such action will either be to cause repayment




29




of the loan with the proceeds of a foreclosure sale or to give us 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. Impaired loans, which primarily consist of non-accruing residential mortgage and commercial real estate loans, totaled $3.44 million at June 30, 2011 and $4.10 million at December 31, 2010 and are included as nonperforming loans in the table above. At June 30, 2011, $1.04 million of impaired loans had specific reserve allocations totaling $209 thousand.


Management monitors asset quality closely and continuously 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. In addition to frequent financial analysis and review of well-rated and adversely graded loans, we incorporate active monitoring of key credit and non-credit risks for each customer, assessing risk through the daily reviews of overdrafts, delinquencies and usage of electronic banking products and tracking for timely receipt of all required financial statements. A management committee reviews the status of these loans each quarter and determines or confirms the appropriate risk rating, accrual status and loan loss reserve allocation. The findings of this review process are instrumental in determining the adequacy of the allowance for credit losses.


Substandard accruing loans totaled $17.01 million at June 30, 2011, a decrease of $1.06 million since December 31, 2010. Of the total substandard accruing loans, $2.85 million are federally guaranteed. The listing of substandard accruing borrowers at June 30, 2011 includes borrowers operating in a variety of different industries and locations. Four borrowers represent 56% of performing classified loans. Loans identified as substandard have well-defined weaknesses that, if not addressed, could result in a loss to the Bank. These accruing substandard loans have generally continued to pay promptly and Management conducts regularly scheduled comprehensive reviews of the borrowers’ financial condition, payment performance, accrual status and collateral. These reviews also ensure that these troubled accounts are properly administered with a focus on loss mitigation and that any potential loss exposures are appropriately quantified, and reserved for. The findings of this review process are a key component in assessing the adequacy of our Loan Loss Reserve.


Concentrations by collateral exposure are also monitored as part of our risk management process. The composition of substandard accruing loans at June 30, 2011 consists of $10.96 million in loans secured by owner occupied commercial real estate, of which $2.07 million is subject to federal loan guarantees; and $3.21 million in commercial investment real estate, of which $78 thousand is government guaranteed. The balance consists of $1.33 million in loans to commercial borrowers, $528 thousand in residential and home equity loans and $987 thousand in loans secured by multi-family residential properties.


Allowance for Credit Losses

The allowance for credit losses is made up of two components - the Allowance for Loan Losses (“ALL”) and the Reserve for Undisbursed Lines. The ALL is based on our 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. We review the adequacy of the ALL quarterly. Factors considered in evaluating the adequacy of the ALL 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 contractual terms and estimated fair values of properties that secure impaired loans.


The adequacy of the ALL is determined using a consistent, systematic methodology, consisting of a review of both specific reserves for loans identified as impaired and general reserves for the various loan portfolio classifications. When a loan is impaired, we determine its impairment loss by comparing 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, the loan is either charged down to its estimated net realizable value, or a specific reserve is established as part of the overall ALL if Management needs more time to evaluate all of the facts and circumstances relevant to that particular loan.


The general ALL 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. Appropriate reserve 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 nonaccrual loans.


Losses are charged against the ALL when Management believes that the collectability of principal is doubtful. To the extent we determine the level of anticipated losses in the portfolio has significantly increased or diminished, the ALL is adjusted through current earnings. Overall, we believe that the ALL 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 ALL.




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The following table summarizes year to date activity in our Allowance for Credit Losses through the dates indicated:


(In thousands)

June 30, 2011

March 31, 2011

December 31, 2010

June 30, 2010

Balance, beginning of year

$10,754 

$10,754 

$11,702 

$11,702 

Charge-offs:

 

 

 

 

    Commercial, financial & agricultural

(77)

(43)

(1,692)

(1,638)

    Real estate – commercial

(60)

(258)

(258)

    Real estate – construction

(11)

(11)

    Real estate –  residential

(49)

(8)

(25)

(5)

    Installment

(8)

(8)

(2)

(2)

        Total charge-offs

(205)

(70)

(1,977)

(1,903)

Recoveries:

 

 

 

 

    Commercial, financial & agricultural

44 

21 

2,128 

38 

    Real estate – commercial

43 

43 

31 

    Real estate – construction

11 

593 

167 

    Real estate – residential

20 

    Installment

        Total recoveries

102 

72 

2,779 

206 

Net (charge-offs) recoveries

(103)

802 

(1,697)

Provision for credit losses

250 

(1,750)

600 

Balance end of period

$10,901 

$10,756 

$10,754 

$10,605 

 

 

 

 

 

Components:

 

 

 

 

        Allowance for loan losses

10,438 

10,232 

10,135 

10,157 

        Reserve for undisbursed lines of credit

463 

524 

619 

448 

Allowance for credit losses

$10,901 

$10,756 

$10,754 

$10,605 


We recorded a provision for credit losses of $250 thousand during the second quarter of 2011.


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


 

June 30, 2011

March 31, 2011

December 31, 2010

June 30, 2010

NPL to total loans

0.37%

0.41%

0.45%

0.93%

NPA to total assets

0.24%

0.26%

0.29%

0.63%

Allowance for loan losses to total loans

1.11%

1.11%

1.11%

1.13%

Allowance for loan losses to NPL

303%

274%

247%

122%


We will continue to take 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 us. There can be no assurances that we will be able to complete the disposition of nonperforming assets without incurring further losses.


Loan Portfolio Monitoring

Our Board of Directors grants each loan officer the authority to originate loans on our behalf, 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 our 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 our credit division manager, senior loan officer, and/or our President. All extensions of credit of $4.0 million or greater to any one borrower, or related party interest, are reviewed and approved by the Loan Committee of our Bank’s Board of Directors.




31




The Loan Committee and the credit department regularly monitor our 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. We monitor 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. Credit risk ratings assessing inherent risk in individual loans are assigned to commercial loans at origination and are routinely reviewed by lenders and Management on a periodic basis according to total exposure and risk rating. These internal reviews assess the adequacy of all aspects of credit administration; additionally we maintain an on-going active monitoring process of loan performance during the year. We have also hired external loan review firms to assist in monitoring both the commercial and residential loan portfolios. The commercial loan review firm reviews at a minimum 60% in dollar volume of our commercial loan portfolio each year. These comprehensive reviews assess the accuracy of the Bank’s risk rating system as well as the effectiveness of credit administration in managing overall credit risks.


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


Item 3.  Quantitative and Qualitative Disclosures About Market Risk


General

Our management and Board of Directors are committed to sound risk management practices throughout the organization. We have developed and implemented a centralized risk management monitoring program. Risks associated with our business activities and products are identified and measured as to probability of occurrence and impact on us (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 our risk profile from a macro perspective; it also serves as a tool for assessing internal controls over financial reporting as required under the Federal Deposit Insurance Corporation Improvement Act 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. Our primary market risk exposure is interest rate risk. An important component of our 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 our 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. Our 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 ALCO. The ALCO, chaired by the Chief Financial Officer and composed of members of senior management, develops guidelines and strategies impacting our 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. We continued to work to maximize net interest income while mitigating risk during the first half of 2011 through 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. We have an outside investment advisory firm which helps us identify opportunities for increased yield, without significantly increasing risk, in the investment portfolio. The firm specializes in stable value and fixed income portfolios. 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.


Liquidity Risk

Our liquidity is measured by our ability to raise cash when needed at a reasonable cost. We must be capable of meeting expected and unexpected obligations to customers at any time. Given the uncertain nature of customer demands as well as the need to maximize earnings, we must have available reasonably priced sources of funds, on- and off-balance sheet that can be accessed quickly in time of need. As discussed previously under “Liquidity and Capital Resources,” we have several sources of readily available funds, including the ability to borrow using our investment portfolio as collateral. We also monitor our liquidity on a quarterly basis in compliance with our Liquidity Contingency Plan. We have expanded our liquidity monitoring process over the last year and have partnered with our ALCO consultant to provide a more robust modeling process that monitors early liquidity stress triggers, and also allow us to model worst case liquidity scenarios, and various responses to those scenarios.




32




During the past several quarters, the financial markets have been challenging for many financial institutions. As a result of these market conditions, liquidity premiums have widened and many banks have experienced liquidity constraints, and as a result have substantially increased pricing to retain deposit balances or utilized the FRB’s discount window to secure adequate funding. Because of our favorable credit quality and strong balance sheet, we have not experienced any liquidity constraints to date. During the past several quarters, our liquidity position has grown, as depositors seek strong financial institutions.


Interest Rate Risk

Interest rate risk is the exposure to a movement in interest rates, which, as described above, affects our net interest income. Asset and liability management is governed by policies reviewed and approved annually by our 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 our 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 our 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 our exposure to changes in interest rates. By using derivative financial instruments to hedge exposures to changes in interest rates we expose ourselves to credit risk and market risk. Credit risk is the failure of the counterparty to perform under the terms of the derivative contract. When the fair value of a derivative contract is positive, the counterparty owes us, which creates credit risk for us. We minimize the credit risk in derivative instruments by entering into transactions only with high-quality counterparties. The market risk associated with interest rate contracts is managed by establishing and monitoring parameters that limit the types and degree of market risk that may be undertaken.


The ALCO is responsible for ensuring that our Bank’s Board of Directors receives accurate information regarding our interest rate risk position at least quarterly. The ALCO uses an outside consultant to perform rate shocks of our balance sheet, and to perform a variety of other analyses. The consultant’s most recent review was as of June 30, 2011. The consultant ran a base simulation assuming no changes in rates as well as a 200 basis point rising and, because rates are quite low, a 100 basis point falling interest rate scenario which assume a parallel and pro rata shift of the yield curve over a one-year period, and no growth assumptions. Additionally, the consultant ran a 400 basis point rising simulation which assumed a parallel shift of the curve over 24 months, and a 500 basis point rising simulation which assumed the curve flattened over a 24 month time frame. A summary of the results is as follows:


Current/Flat Rates: Net interest income is projected to trend downward in the current rate scenario as the expected replacement rates on assets are lower than the current portfolio, and opportunities to reduce rates on deposits and term funding are limited.


Falling Rates: If rates fall, net interest income is projected to trend slightly above the base case scenario in year one as rate reductions in the funding base offset lower asset yields. Thereafter net interest income trends downward as funding rate reductions subside while asset cash flow continues to reset at reduced yields. Accelerated prepayment speeds on mortgage-based assets exacerbate the impact of lower rates.


Rising Rates: Net interest income levels are projected to move sideways over year one of an up 200 basis points yield curve shift as higher asset yields on our floating rate loan portfolio are offset by elevated deposit rates. Later in the scenario margins widen out as higher funding costs slow while asset yields trend upward. A more pronounced rising rate scenario is projected to trend slightly lower than the up 200 basis points scenario over the first two years due to additional pricing pressure on deposit rates, but eventually moves upward. A flattening up 500 basis points scenario trends slightly above the base case over the first two years as the rate sensitive deposit base prices immediately and offsets any benefit to the short-term asset base. However, margins trend higher over the long-term due to the asset sensitive structure of the balance sheet.


The change in net interest income for the next twelve months from our expected or “most likely” forecast at the June 30, 2011 review is shown in the following table. The degree to which this exposure materializes will depend, in part, on our ability to manage deposit rates as interest rates rise or fall.


Rate Change

Percent Change in
Net Interest Income

Up 200 basis points

1.51%

Down 100 basis points

0.44%




33




The ALCO uses off-balance sheet strategies, such as interest rate caps and floors and interest rate swaps, as well as borrowings with embedded caps and floors to help minimize our exposure to changes in interest rates. As mentioned previously, we entered into interest rate swap arrangements to fix the cost of our trust preferred issuance that switched to a floating interest rate in December 2009.


The preceding sensitivity analysis does not represent our forecast and should not be relied upon as indicative of expected operating results. These estimates are based upon numerous assumptions, including, among others, 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. While assumptions are developed based upon current economic and local market conditions, as well as historical behavior, we cannot make any assurances as to the predictive nature of these assumptions, including how customer preferences or competitor influences might change.


The most significant factor affecting market risk exposure of net interest income during the first half of 2011 was the severe nationwide recession followed by a modest recovery, and the U.S. Government’s response. Interest rates declined sharply during 2008 and have remained low throughout 2010 and the first half of 2011 as the global economy slowed, unemployment levels increased, delinquencies on all types of loans increased along with decreased consumer confidence and declines in housing prices. Interest rates remain low in spite of a modest economic recovery. Net interest income exposure is also significantly affected by 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.


The model used to perform the balance sheet simulation assumes a parallel shift of the yield curve over twelve months and reprices every interest earning asset and interest bearing liability on our 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 LifeÒ 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 published by Applied Financial Technologies.


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 the ALCO might take in responding to or anticipating changes in interest rates.


Credit Risk

Our Bank’s Board of Directors reviews and approves our Bank’s investment and loan policies on an annual basis. The investment policy establishes minimum investment quality guidelines, as well as specific limits on asset classes within the investment portfolio. Our Bank’s outside investment advisor tracks Non-Agency securities individually and presents at least quarterly updates on the performance of the underlying collateral. The loan policy establishes restrictions regarding the types of loans that may be granted, and the distribution of loan types within our portfolio. Our Bank’s Board of Directors grants each loan officer the authority to originate loans on our behalf, subject to certain limitations. These authorized lending limits are reviewed at least annually and are based upon the officer’s knowledge and experience. Loan requests that exceed an officer’s authority require the signature of our senior credit officer, senior loan officer, and/or president. All extensions of credit of $4.0 million or greater to any one borrower or related party are reviewed and approved by the Loan Committee of our Bank’s Board of Directors. Our loan portfolio is continuously monitored for performance, creditworthiness and strength of documentation through the use of a variety of management reports and with the assistance of an external loan review firm. Credit ratings are assigned to commercial loans and are routinely reviewed. Loan officers or the loan workout function take remedial actions to assure full and timely payment of loan balances when necessary.


Item 4.  Controls and Procedures


The principal executive officer, principal financial officer, and other members of our senior management have evaluated our disclosure controls and procedures as of the end of the period covered by this quarterly report. Based on this evaluation, our principal executive officer and principal financial officer have concluded that the disclosure controls and procedures effectively ensure that information required to be disclosed in our filings and submissions with the SEC under the Securities Exchange Act of 1934, as amended, is accumulated and communicated to our management (including the principal executive officer and principal financial officer), and is recorded, processed, summarized and reported within the time periods specified by the SEC. In addition, we have reviewed our internal control over financial reporting and there have been no changes in our internal control over financial reporting during the quarter ended June 30, 2011 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.




34




MERCHANTS BANCSHARES, INC.

PART II – OTHER INFORMATION


Item 1.  Legal Proceedings


None.


Item 1A.  Risk Factors


Please read the factors discussed in Part I – Item 1A, "Risk Factors" in our Annual Report on Form 10-K for the fiscal year ended December 31, 2010 filed with the SEC on March 15, 2011, which could materially adversely affect our business, financial condition and operating results. These risks are not the only ones facing us. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and operating results.


General economic and market conditions in the United States of America and abroad may materially and adversely affect the market price of shares of our 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 our judgments as of the date of this Form 10-Q and we undertake no duty to update these forward-looking statements. We caution readers not to place undue reliance on such statements.


Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds


None.


Item 3.  Defaults Upon Senior Securities


None.


Item 4.  [Removed and Reserved]


Item 5.  Other Information


None.


Item 6.  Exhibits


(a)  Exhibits:


 

10.1

 

Amended and Restated Merchants Bancshares, Inc. 2008 Stock Incentive Plan (Incorporated by reference to Exhibit 10.1 to Merchants’ Current Report on Form 8-K filed on May 6, 2011)

 

 

 

 

 

31.1*

 

Certification of Chief Executive Officer Pursuant to Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934, as amended

 

 

 

 

 

31.2*

 

Certification of Chief Financial Officer Pursuant to Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934, as amended

 

 

 

 

 

32.1**

 

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




35





 

101***

 

The following materials from Merchants Bancshares, Inc.’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2011 formatted in XBRL: (i) Consolidated Balance Sheets at June 30, 2011 and December 31, 2010; (ii) Consolidated Statements of Income for the three and six months ended June 30, 2011 and 2010; (iii) Consolidated Statements of Comprehensive Income for the three and six months ended June 30, 2011 and 2010; (iv) Consolidated Statements of Cash Flows for the six months ended June 30, 2011 and 2010; and (v) Notes to Interim Unaudited Consolidated Financial Statements.


_______________________________

*

Filed herewith

**

Furnished herewith

***

Pursuant to Rule 406T of Regulation S-T, the XBRL related information in Exhibit 101 to this Quarterly Report on Form 10-Q is furnished and not filed for purposes of Sections 11 and 12 of the Securities Act of 1933 and Section 18 of the Securities Exchange Act of 1934.



MERCHANTS BANCSHARES, INC.

SIGNATURES


Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


 

Merchants Bancshares, Inc.

 

 

 

 

 

/s/ Michael R. Tuttle

 

Michael R. Tuttle
President & Chief Executive Officer

 

 

 

 

 

/s/ Janet P. Spitler

 

Janet P. Spitler
Chief Financial Officer & Treasurer
Principal Accounting Officer

 

 

 

August 8, 2011

 

Date





36