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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 period ended: June 30, 2003
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
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Commission file number 0-11595
Merchants Bancshares, Inc.
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(Exact name of registrant as specified in its charter)
Delaware 03-0287342
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
275 Kennedy Drive, South Burlington, Vermont 05403
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(Address of principal executive offices) (Zip Code)
802-658-3400
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(Registrant's telephone number, including area code)
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(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 is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
[X] Yes [ ] No
Indicate the number of shares outstanding of each of the issuer's classes
of common stock, as of the latest practicable date: As of August 8, 2003,
the registrant had outstanding 6,180,468 shares of Common Stock, par value
$0.01 per share.
MERCHANTS BANCSHARES, INC.
FORM 10-Q
TABLE OF CONTENTS
PART I - FINANCIAL INFORMATION
ITEM 1. Financial Statements (Unaudited)
Consolidated Balance Sheets
June 30, 2003, and December 31, 2002 1
Consolidated Statements of Operations
For the three months ended June 30, 2003 and 2002, and
the six months ended June 30, 2003 and 2002 2
Consolidated Statements of Comprehensive Income
For the three months ended June 30, 2003 and 2002, and
the six months ended June 30, 2003 and 2002 3
Consolidated Statements of Cash Flows
For the six months ended June 30, 2003 and 2002 4
Notes to Consolidated Financial Statements 5 - 7
ITEM 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 7 - 15
ITEM 3. Quantitative and Qualitative Disclosures about Market Risk 15 - 17
ITEM 4. Controls and Procedures 17
PART II - OTHER INFORMATION
ITEM 1. Legal Proceedings 18
ITEM 2. Changes in Securities and Use of Proceeds 18
ITEM 3. Defaults upon Senior Securities 18
ITEM 4. Submission of Matters to a Vote of Security Holders 18
ITEM 5. Other Information 18
ITEM 6. Exhibits and Reports on Form 8-K 18
Signatures 19
Exhibits
MERCHANTS BANCSHARES, INC.
PART I-Financial Information
ITEM 1. FINANCIAL STATEMENTS
Merchants Bancshares, Inc.
Consolidated Balance Sheets
(Unaudited)
June 30, December 31,
(In thousands except share and per share data) 2003 2002
- -------------------------------------------------------------------------------------------------
ASSETS
Cash and Due from Banks $ 35,457 $ 37,046
Federal Funds Sold and Other Short-term Investments 513 31,500
Investments:
Securities Available for Sale 256,215 217,755
Securities Held to Maturity
(Fair Value of $44,591 and $54,972) 41,937 51,614
Trading Securities 760 846
- -----------------------------------------------------------------------------------------------
Total Investments 298,912 270,215
- -----------------------------------------------------------------------------------------------
Loans 540,670 495,588
Less: Allowance for Loan Losses 7,887 8,497
- -----------------------------------------------------------------------------------------------
Net Loans 532,783 487,091
- -----------------------------------------------------------------------------------------------
Federal Home Loan Bank Stock 3,632 3,632
Bank Premises and Equipment, Net 11,343 11,400
Investment in Real Estate Limited Partnerships 4,608 3,551
Other Real Estate Owned -- 57
Other Assets 10,625 10,003
- -----------------------------------------------------------------------------------------------
Total Assets $ 897,873 $854,495
===============================================================================================
LIABILITIES
Deposits:
Demand Deposits $ 100,441 $102,554
Savings, NOW and Money Market Accounts 488,717 467,430
Time Deposits $100 Thousand and Greater 44,812 37,916
Other Time Deposits 155,462 147,374
- -----------------------------------------------------------------------------------------------
Total Deposits 789,432 755,274
- -----------------------------------------------------------------------------------------------
Demand Note Due U.S. Treasury 1,661 4,000
Other Liabilities 14,721 10,086
Long-Term Debt 6,257 2,377
- -----------------------------------------------------------------------------------------------
Total Liabilities 812,071 771,737
- -----------------------------------------------------------------------------------------------
Commitments and Contingencies (Note 5)
STOCKHOLDERS' EQUITY
Preferred Stock Class A Non-Voting
Shares Authorized - 200,000, Outstanding 0 -- --
Preferred Stock Class B Voting
Shares Authorized - 1,500,000, Outstanding 0 -- --
Common Stock, $.01 Par Value 67 67
Shares Authorized 10,000,000
Issued Current Period 6,651,760
Prior Period 6,651,760
Outstanding Current Period 5,922,879
Prior Period 5,925,082
Capital in Excess of Par Value 33,852 33,664
Retained Earnings 58,635 55,827
Treasury Stock, At Cost (11,383) (10,980)
Current Period Shares 728,881
Prior Period Shares 726,678
Deferred Compensation Arrangements 3,342 3,194
Accumulated Other Comprehensive Income 1,289 986
- -----------------------------------------------------------------------------------------------
Total Stockholders' Equity 85,802 82,758
- -----------------------------------------------------------------------------------------------
Total Liabilities and Stockholders' Equity $ 897,873 $854,495
===============================================================================================
See accompanying notes to the consolidated financial statements
1
Merchants Bancshares, Inc.
Consolidated Statements of Operations
(Unaudited)
Three Months Ended Six Months Ended
June 30, June 30,
(In thousands except per share data) 2003 2002 2003 2002
- -----------------------------------------------------------------------------------------
INTEREST AND DIVIDEND INCOME
Interest and Fees on Loans $ 8,304 $ 8,527 $16,336 $17,183
Interest and Dividends on Investments
U.S. Treasury and Agency Obligations 2,031 2,811 4,456 5,527
Other 1,041 805 1,908 1,564
- -----------------------------------------------------------------------------------------
Total Interest and Dividend Income 11,376 12,143 22,700 24,274
- -----------------------------------------------------------------------------------------
INTEREST EXPENSE
Savings, NOW and Money Market Accounts 808 1,379 1,686 2,849
Time Deposits $100 Thousand and Greater 266 335 612 693
Other Time Deposits 932 1,094 1,805 2,303
Other Borrowed Funds 11 4 13 14
Long-Term Debt 45 20 72 39
- -----------------------------------------------------------------------------------------
Total Interest Expense 2,062 2,832 4,188 5,898
- -----------------------------------------------------------------------------------------
Net Interest Income 9,314 9,311 18,512 18,376
Provision for Loan Losses -- (181) -- (614)
- -----------------------------------------------------------------------------------------
Net Interest Income after Provision
for Loan Losses 9,314 9,492 18,512 18,990
- -----------------------------------------------------------------------------------------
NONINTEREST INCOME
Trust Company Income 369 450 714 839
Service Charges on Deposits 1,097 1,031 2,147 1,953
Net Gains on Sales of Investment Securities 626 -- 843 --
Other 657 250 1,126 682
- -----------------------------------------------------------------------------------------
Total Noninterest Income 2,749 1,731 4,830 3,474
- -----------------------------------------------------------------------------------------
NONINTEREST EXPENSES
Salaries and Wages 2,922 2,587 5,659 5,263
Employee Benefits 891 846 1,971 1,731
Occupancy Expense, Net 672 585 1,365 1,219
Equipment Expense 664 611 1,263 1,206
Legal and Professional Fees 385 423 696 749
Marketing 357 261 658 511
Equity in Losses of Real Estate
Limited Partnerships 401 329 803 647
Vermont Franchise Taxes 213 203 359 402
Other Real Estate Owned, Net 35 44 59 75
Other 1,275 1,165 2,553 2,358
- -----------------------------------------------------------------------------------------
Total Noninterest Expenses 7,815 7,054 15,386 14,161
- -----------------------------------------------------------------------------------------
Income Before Provision for Income Taxes 4,248 4,169 7,956 8,303
Provision for Income Taxes 1,208 1,152 2,182 2,280
- -----------------------------------------------------------------------------------------
NET INCOME $ 3,040 $ 3,017 $ 5,774 $ 6,023
=========================================================================================
Basic Earnings Per Common Share $ 0.49 $ 0.49 $ 0.93 $ 0.98
Diluted Earnings Per Common Share $ 0.49 $ 0.48 $ 0.93 $ 0.97
See accompanying notes to the consolidated financial statements
2
Merchants Bancshares, Inc.
Consolidated Statements of Comprehensive Income
(Unaudited)
Three Months Ended Six Months Ended
June 30, June 30,
(In thousands) 2003 2002 2003 2002
- --------------------------------------------------------------------------------------------------
Net Income $3,040 $3,017 $5,774 $6,023
Change in Net Unrealized Appreciation of Securities
Available for Sale, Net of Tax 617 2,180 871 856
Change in Net Unrealized Appreciation of
Derivatives Qualifying as Hedges, Net of Tax -- 379 -- 379
Reclassification Adjustments for Securities
(Gains)/Losses Included in Net Income,
Net of Tax (407) -- (548) --
- --------------------------------------------------------------------------------------------------
Comprehensive Income Before Transfers 3,250 5,576 6,097 7,258
Impact of Transfer of Securities from Available for Sale
to Held to Maturity (8) (5) (20) (12)
- --------------------------------------------------------------------------------------------------
Comprehensive Income $3,242 $5,571 $6,077 $7,246
==================================================================================================
See accompanying notes to the consolidated financial statements
3
Merchants Bancshares, Inc.
Consolidated Statements of Cash Flows
(Unaudited)
For the six months ended June 30, 2003 2002
- ------------------------------------------------------------------------------------------------
(In thousands)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net Income $ 5,774 $ 6,023
Adjustments to Reconcile Net Income to Net Cash
Provided by Operating Activities:
Provision for Loan Losses -- (614)
Depreciation and Amortization 2,315 1,657
Net Gains on Sales of Investment Securities (843) --
Net Losses (Gains) on Disposition of Premises and Equipment 47 (8)
Net Gains on Sales of Other Real Estate Owned (8) --
Equity in Losses of Real Estate Limited Partnerships 803 647
Changes in Assets and Liabilities:
Increase in Interest Receivable (204) (877)
Decrease in Interest Payable (68) (591)
(Decrease) Increase in Other Assets (590) 217
Increase (Decrease) in Other Liabilities 4,708 (4,301)
- ------------------------------------------------------------------------------------------------
Net Cash Provided by Operating Activities 11,934 2,153
- ------------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from Sales of Investment Securities Available for Sale 65,178 --
Proceeds from Maturities of Investment Securities Available for Sale 28,749 20,432
Proceeds from Maturities of Investment Securities Held to Maturity 9,647 7,874
Purchases of Investment Securities Available for Sale (132,074) (88,609)
Loan Originations (in Excess of) Less than Principal Payments (45,850) 6,070
Purchases of Federal Home Loan Bank Stock -- (12)
Proceeds from Sales of Premises and Equipment -- 8
Proceeds from Sales of Other Real Estate Owned 65 --
Investments in Real Estate Limited Partnerships (1,860) (743)
Purchases of Bank Premises and Equipment (890) (967)
- ------------------------------------------------------------------------------------------------
Net Cash Used in Investing Activities (77,035) (55,947)
- ------------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net Increase in Deposits 34,158 15,962
Net (Decrease) Increase in Short Term Borrowings (2,339) 2,147
Proceeds from Long-Term Debt 4,000 --
Principal Payments on Long-Term Debt (120) (9)
Cash Dividends Paid (2,529) (2,283)
Acquisition of Treasury Stock (713) (345)
Increase in Deferred Compensation Arrangements 80 187
Distributions Under Deferred Compensation Arrangements (141) (147)
Proceeds from the Exercise of Employee Stock Options 129 225
- ------------------------------------------------------------------------------------------------
Net Cash Provided by Financing Activities 32,525 15,737
- ------------------------------------------------------------------------------------------------
Decrease in Cash and Cash Equivalents (32,576) (38,057)
Cash and Cash Equivalents Beginning of Year 68,546 86,688
- ------------------------------------------------------------------------------------------------
Cash and Cash Equivalents End of Period $ 35,970 $ 48,631
================================================================================================
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Total Interest Payments $ 4,256 $ 6,489
Total Income Tax Payments 3,457 3,650
SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES
Distribution of Stock Under Deferred Compensation Arrangements 55 55
Distribution of Treasury Stock in Lieu of Cash Dividend 437 552
See accompanying notes to the consolidated financial statements
4
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS:
See Merchants Bancshares, Inc. ("Merchants") Annual Report on Form 10-K for
additional information.
Note 1: Recent Accounting Developments
In May 2003 the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 150, "Accounting
for Certain Financial Instruments with Characteristics of Both Liabilities
and Equity". This Statement establishes standards for how an issuer
classifies and measures certain financial instruments with characteristics
of both liabilities and equity. It requires that an issuer classify a
financial instrument that is within its scope as a liability (or an asset
in some circumstances). Many of those instruments were previously
classified as equity. This Statement is generally effective for financial
instruments entered into or modified after May 31, 2003, and otherwise is
effective at the beginning of the first interim period beginning after June
15, 2003. The adoption of this statement has not had a material impact on
Merchants' financial position or results of operations.
In April 2003 the FASB issued SFAS No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities". This Statement amends and
clarifies financial accounting and reporting for derivative instruments,
including certain derivative instruments embedded in other contracts
(collectively referred to as derivatives) and for hedging activities under
FASB Statement No. 133, "Accounting for Derivative Instruments and Hedging
Activities." This Statement is generally effective for contracts entered
into or modified after June 30, 2003, and for hedging relationships
designated after June 30, 2003. The adoption of this statement has not had
a material impact on Merchants' financial position or results of
operations.
In December 2002 the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure - an Amendment of FASB Statement
No. 123", to provide alternative methods of transition for a voluntary
change to the fair value based method of accounting for stock-based
employee compensation. In addition, SFAS No. 148 amends the disclosure
requirements of SFAS No. 123 to require prominent disclosures in both
annual and interim financial statements about the method of accounting for
stock-based employee compensation and the effect of the method used on
reported results. This statement is effective for fiscal years ending after
December 15, 2002. The adoption of this statement changed certain
disclosures but did not impact Merchants' financial position or results of
operations.
Note 2: Stock-Based Compensation
Merchants has granted stock options to certain key employees. The options
granted vest completely after two years and are immediately exercisable
upon vesting. Nonqualified stock options may be granted at any price
determined by the Compensation Committee of Merchants' Board of Directors.
All stock options have been granted at or above fair market value at the
date of grant.
Merchants accounts for its stock-based compensation plans in accordance
with the provisions of Accounting Principles Board ("APB") Opinion No. 25,
"Accounting for Stock Issued to Employees," and related interpretations.
Merchants has adopted SFAS No. 123, "Accounting for Stock-Based
Compensation," which permits entities to recognize the fair value of all
stock-based awards measured on the date of the grant as expense over the
vesting period, and has adopted SFAS No. 148 "Accounting for Stock-Based
Compensation - Transition and Disclosure - an Amendment of FASB Statement
No. 123," which, among other things, amends the disclosure requirements of
SFAS No. 123. Alternatively, SFAS No. 123 allows entities to continue to
apply the provisions of APB Opinion No. 25 and provide pro forma net income
and earnings per share disclosures for employee stock-based grants made in
1995 and future years as if the fair value based method defined in SFAS No.
123 had been applied. Merchants has elected to continue to apply the
provisions of APB Opinion No. 25 and provide the pro forma disclosure
required by SFAS No. 123.
The fair value of each option grant is estimated on the grant date using
the Black-Scholes option-pricing model. No options have been granted since
August 2001. Merchants' net income and earnings per share would have been
the same as the amounts reported in the financial statements had
compensation cost for awards under Merchants' stock-based compensation
plans been determined consistent with the method set forth under SFAS No.
123. Pro forma compensation expense for options granted is reflected over
the vesting period; therefore, future pro forma compensation expense may be
greater if additional options are granted.
5
Note 3: Earnings Per Share
The following tables present reconciliations of the calculations of basic
and diluted earnings per share for the three and six month periods ended
June 30, 2003 and 2002.
Weighted
Net Average Per Share
Three Months Ended June 30, 2003 Income Shares Amount
(In thousands except share and per share data)
- ------------------------------------------------------------------------------------------------
Basic Earnings Per Common Share:
Net Income Available to Common
Shareholders $3,040 6,182,218 $0.49
Diluted Earnings Per Common Share:
Effect of Dilutive Stock Options -- 54,867
Net Income Available to Common
Shareholders and Stock Option Exercise $3,040 6,237,085 $0.49
Weighted
Net Average Per Share
Three Months Ended June 30, 2002 Income Shares Amount
(In thousands except share and per share data)
- ------------------------------------------------------------------------------------------------
Basic Earnings Per Common Share:
Net Income Available to Common
Shareholders $3,017 6,162,327 $0.49
Diluted Earnings Per Common Share:
Effect of Dilutive Stock Options -- 84,612
Net Income Available to Common
Shareholders and Stock Option Exercise $3,017 6,246,939 $0.48
Weighted
Net Average Per Share
Six Months Ended June 30, 2003 Income Shares Amount
(In thousands except share and per share data)
- ------------------------------------------------------------------------------------------------
Basic Earnings Per Common Share:
Net Income Available to Common
Shareholders $5,774 6,182,335 $0.93
Diluted Earnings Per Common Share:
Effect of Dilutive Stock Options -- 54,363
Net Income Available to Common
Shareholders and Stock Option Exercise $5,774 6,236,698 $0.93
Weighted
Net Average Per Share
Six Months Ended June 30, 2002 Income Shares Amount
(In thousands except share and per share data)
- ------------------------------------------------------------------------------------------------
Basic Earnings Per Common Share:
Net Income Available to Common
Shareholders $6,023 6,153,185 $0.98
Diluted Earnings Per Common Share:
Effect of Dilutive Stock Options -- 78,954
Net Income Available to Common
Shareholders And Stock Option Exercise $6,023 6,232,139 $0.97
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 month periods ending June 30, 2003 and 2002. As of June 30, 2003
and 2002, there were no anti-dilutive stock options outstanding.
6
Note 4: Stock Repurchase Program
In January 2001 Merchants' Board of Directors approved a stock repurchase
program. In January 2003 the Board of Directors voted to extend the program
until January 2004. Under the program, Merchants is authorized to
repurchase up to 300,000 shares of its own common stock. Under the plan
Merchants purchased 177,881 shares of its own common stock on the open
market, at an average per share price of $21.52, through June 30, 2003.
Note 5: Commitments and Contingencies
Merchants is involved in routine legal proceedings occurring in the
ordinary course of business, which, in the aggregate, are believed by
management to be immaterial to its financial condition and results of
operations
Note 6: Guarantees
Merchants does not issue any guarantees that would require liability
recognition or disclosure, other than its standby letters of credit.
Standby letters of credit are conditional commitments issued by Merchants
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 $6.4
million at June 30, 2003, and represent the maximum potential future
payments Merchants could be required to make. Typically, these instruments
have terms of 12 months or less and expire unused; therefore, the total
amounts do not necessarily represent future cash requirements. Each
customer is evaluated individually for creditworthiness under the same
underwriting standards used for commitments to extend credit and on-balance
sheet instruments. Merchants policies governing loan collateral apply to
standby letters of credit at the time of credit extension. Loan-to-value
ratios are generally consistent with loan-to-value requirements for other
commercial loans secured by similar types of collateral. The fair value of
the Merchants' standby letters of credit at June 30, 2003, was
insignificant.
Note 7: Reclassifications
Certain amounts reported for prior periods have been reclassified to be
consistent with the current period presentation.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Forward-Looking Statements
Except for the historical information contained herein, this Quarterly
Report on Form 10-Q of Merchants Bancshares, Inc. may contain forward-
looking statements within the meaning of Section 27A of the Securities Act
of 1933 and Section 21E of the Securities Exchange Act of 1934. Investors
are cautioned that forward-looking statements are inherently uncertain.
Actual performance and results of operations may differ materially from
those projected or suggested in the forward-looking statements due to
certain risks and uncertainties, including, without limitation:
(i) the fact that Merchants' success is dependent upon general
economic conditions in Vermont and Vermont's ability to
attract new business;
(ii) the fact that Merchants' earnings depend to a great extent
upon the level of net interest income (the difference between
interest income earned on loans and investments and the
interest expense paid on deposits and other borrowings)
generated by Merchants and thus Merchants' results of
operations may be adversely affected by increases or decreases
in interest rates;
(iii) the fact that the banking business is highly competitive and
the profitability of Merchants depends upon Merchants' ability
to attract loans and deposits in Vermont, where Merchants
competes with a variety of traditional banking and
nontraditional institutions such as credit unions and finance
companies;
(iv) the fact that at June 30, 2003, a significant portion of
Merchants' loan portfolio was comprised of commercial loans,
exposing Merchants to the risks inherent in financings based
upon analyses of credit risk, the value of underlying
collateral, including real estate, and other more intangible
factors, which are considered in making commercial loans;
(v) approximately 80% of Merchants' loan portfolio is comprised of
real estate loans, exposing Merchants to the risks inherent in
financings based upon analyses of credit risk and the value of
underlying collateral. Accordingly, Merchants' profitability
may be negatively impacted by errors in risk analyses, by loan
defaults, and the ability of certain borrowers to repay such
loans may be adversely affected by any downturn in general
economic conditions;
7
(vi) acts or threats of terrorism and actions taken by the United
States or other governments as a result of such acts or
threats, including possible military action, could further
adversely affect business and economic conditions in the
United States generally and in Merchants' markets, which could
adversely effect Merchants' financial performance and that of
Merchants' borrowers and on the financial markets and the
price of Merchants' common stock;
(vii) changes in the extensive laws, regulations and policies
governing bank holding companies and their subsidiaries could
alter Merchants' business environment or affect Merchants'
operations; and
(viii) the potential need to adapt to industry changes in information
technology systems, on which Merchants is highly dependent,
could present operational issues or require significant
capital spending.
These factors, as well as general economic and market conditions in the
United States, may materially and adversely affect the market price of
shares of Merchants' common stock. Because of these and other factors, past
financial performance should not be considered an indicator of future
performance. The forward-looking statements contained herein represent
Merchants' judgment as of the date of this Form 10-Q, and Merchants
cautions readers not to place undue reliance on such statements.
General
All adjustments necessary for a fair presentation of the consolidated
financial statements of Merchants as of and for the six months ended June
30, 2003 and 2002, have been included. The information was prepared from
the unaudited financial statements of Merchants Bancshares, Inc. and its
subsidiaries, Merchants Bank, Merchants Trust Company and Merchants
Properties, Inc.
Overview
Merchants earned net income of $3.04 million, or basic and diluted earnings
per share of 49 cents for the quarter ended June 30, 2003, compared to
$3.02 million, or basic earnings per share of 49 cents and diluted earnings
per share of 48 cents for the same period a year earlier. The return on
average assets and return on average equity for the second quarter of 2003
were 1.39% and 14.38% respectively, compared to 1.50% and 15.53% for the second
quarter of 2002. Merchants earned net income of $5.77 million, or basic and
diluted earnings per share of 93 cents for the six months ended June 30,
2003, compared to $6.02 million, or basic earnings per share of 98 cents
and diluted earnings per share of 97 cents for the same period a year
earlier. The return on average assets and return on average equity for the
first six months of 2003 were 1.34% and 13.77% respectively, compared to
1.50% and 15.61% respectively for the first six months of 2002.
Results of Operations
Net Interest Income: Net interest income for the second quarter of 2003 was
unchanged from the same quarter a year ago at $9.3 million and was $18.5
million for the first half of 2003 compared to $18.4 million for the same
period in 2002. Although Merchants' net interest margin has continued to
come under pressure over the last twelve months, overall balance sheet
growth has helped to offset some of this margin compression. The net
interest margin for the second quarter of 2003 has decreased by 40 basis
points, from 4.95% to 4.55%, compared to the second quarter of 2002, and
has decreased by 32 basis points, from 4.93% to 4.61%, for the first half
of 2003 compared to 2002. This decrease reflects the effect of the current
prolonged low interest rate environment, which, if it continues, is likely
to negatively impact the net interest margin for the remainder of 2003. The
yield on interest earning assets continued to decrease at a faster pace
than the cost of interest bearing liabilities during the quarter. The yield
on interest earning assets decreased 89 basis points for the second quarter
of 2003 compared to 2002, and 85 basis points for the first six months of
2003 compared to 2002. At the same time, the cost of interest bearing
liabilities for the second quarter decreased 59 basis points, and 64 basis
points for the first six months of this year compared to last year. The
schedules on pages 10-11 show the yield analysis for the periods reported.
The average interest rate earned on the loan portfolio decreased from 7.25%
in the second quarter of 2002 to 6.23% in the second quarter of 2003. This
is a result of both lower interest rates and changes in the makeup of
Merchants' commercial and commercial real estate loan portfolios.
Merchants' commercial real estate portfolio totaled $192 million at June
30, 2003, variable rate loans make up over 75% of the portfolio. At June
30, 2002, the commercial real estate portfolio was $167 million and just
over 60% were variable rate loans. Merchants' commercial loan portfolio has
experienced a similar shift. The commercial loan portfolio at June 30,
2003, was $92 million, with variable rate loans comprising over 70% of the
total, as contrasted with June 30, 2002 balances of $86 million, with
variable rate loans comprising less than 60% of the total. Merchants'
customers have continued to refinance their current debt to take advantage
of the favorable interest rate environment. This shift has helped to
exacerbate the current margin compression, but has also had the effect of
moving Merchants' balance sheet to an asset-sensitive interest rate gap
position, which should leave Merchants well poised for a rise in interest
rates.
8
Deposit costs have also moved down over the last year, but not as quickly
as loan yields. The average rate on Savings, NOW and Money Market accounts
has decreased from 1.22% for the second quarter of 2002 to 0.67% for the
second quarter of the current year; for the first half of the year the rate
has decreased from 1.27% in 2002 to 0.72% in 2003. The cost of Merchants'
premier product, Free Checking for Life(R), has decreased from an average rate
of 0.61% for the month of June of 2002 to 0.48% for the month of June of
2003. The cost of time deposits has decreased from 3.28% to 2.43% quarter
over quarter, and has decreased from 3.49% to 2.51% for the first six
months of 2003 compared to 2002.
Provision for Loan Losses: In recent years, Merchants has recorded its
recoveries on previously charged off obligations as a negative loan loss
provision. As a result of declines in the unallocated portion of the
allowance for loan losses, Merchants has discontinued its practice of
recording these recoveries as negative loan loss provisions. Merchants
recorded charge-offs of $681 thousand and recoveries of $71 thousand during
the first two quarters of 2003. The amount of the negative provision for
the first six months of last year was $614 thousand. The allowance for loan
losses is reviewed quarterly by management and continues to be deemed
adequate under current market conditions. See the discussion of Non-
Performing Assets on pages 13 - 16 for more information on the allowance
for loan losses.
Noninterest income: Total noninterest income increased $1.02 million from
the second quarter of 2002 to the second quarter of 2003, and by $1.36
million for the first six months of 2003 compared to the same period of
2002. Excluding net gains on sales of investments of $626 thousand for the
second quarter of 2003 and $843 thousand for the first six months of the
year, total noninterest income increased $392 thousand from the second
quarter of 2002 to the second quarter of 2003 and by $513 thousand for the
first six months of 2003 compared to the same period of 2002. The increase
is due primarily to increases in net ATM and debit card revenue and
overdraft service charge revenue. Merchants' ATM and debit card revenue,
net of expenses, increased $72 thousand for the second quarter of 2003 and
$97 thousand for the first six months of 2003 compared to the same period
in 2002. Merchants' overdraft fee revenue increased $155 thousand from
$1.21 million for the first six months of 2002 to $1.37 million during the
first six months of 2003; and increased $50 thousand for the second quarter
of 2003 compared to 2002. Merchants Trust Company income for the second
quarter of this year was $81 thousand less than the same quarter of 2002,
and was $125 thousand less than 2002 for the first six months of the year.
This decrease was primarily due to continuing reductions in asset market
values, changes in the Trust Company's fee schedule and the realignment of
resources as a result of the decision made in 2002 to discontinue brokerage
advisory and discount brokerage services.
9
Merchants Bancshares, Inc.
Average Balance Sheets and Average Rates
(Unaudited)
(Dollars in Thousands, Fully Taxable Equivalent) Three Months Ended
----------------------------------------------------------------
June 30, 2003 June 30, 2002
Interest Interest
Average Income/ Average Average Income/ Average
Balance Expense Rate Balance Expense Rate
------------------------------ ------------------------------
INTEREST EARNING ASSETS
Loans (1) (2) $534,569 $ 8,308 6.23% $472,159 $ 8,534 7.25%
Taxable Investments 273,564 3,028 4.44% 262,305 3,528 5.39%
Federal Funds Sold and Securities Purchased
Under Agreements to Resell 12,781 44 1.38% 21,056 88 1.68%
---------------------------- ----------------------------
Total Interest Earning Assets $820,914 $11,380 5.56% $755,520 $12,150 6.45%
---------------------------- ----------------------------
Noninterest Earning Assets 50,922 50,667
-------- --------
Total Assets $871,836 $806,187
======== ========
INTEREST BEARING LIABILITIES
Interest Bearing Deposits:
Savings, NOW and Money Market Deposits $480,244 $ 807 0.67% $455,074 $ 1,379 1.22%
Time Deposits 198,026 1,198 2.43% 174,266 1,427 3.28%
---------------------------- ----------------------------
Total Savings and Time Deposits 678,270 2,005 1.19% 629,340 2,806 1.79%
---------------------------- ----------------------------
Federal Funds Purchased and Securities Sold
Under Agreements to Repurchase 33 -- 1.52% -- -- --
Short-Term Borrowings 2,284 11 1.93% 1,147 4 1.40%
Long-Term Debt 6,287 46 2.93% 2,420 20 3.31%
---------------------------- ----------------------------
Total Interest Bearing Liabilities 686,874 2,062 1.20% 632,907 2,830 1.79%
---------------------------- ----------------------------
Noninterest Bearing Deposits 93,085 89,954
Other Liabilities 7,307 5,615
Sotckholders' Equity 84,570 77,711
-------- --------
Total Liabilities and Stockholders' Equity 871,836 806,187
======== ========
Net Earning Assets $134,040 $122,613
======== ========
Net Interest Income (Fully Taxable Equivalent) $ 9,318 $ 9,320
======= =======
Net Interest Rate Spread 4.36% 4.66%
==== ====
Net Interest Margin 4.55% 4.95%
==== ====
Includes principal balance of non-accrual loans and fees on loans.
Excludes prepayment fees of $165 related to early payments by certain
loan customers in 2002.
10
Merchants Bancshares, Inc.
Average Balance Sheets and Average Rates
(Unaudited)
(Dollars in Thousands, Fully Taxable Equivalent) Six Months Ended
----------------------------------------------------------------
June 30, 2003 June 30, 2002
Interest Interest
Average Income/ Average Average Income/ Average
Balance Expense Rate Balance Expense Rate
------------------------------ ------------------------------
INTEREST EARNING ASSETS
Loans (1) (2) $516,273 $16,345 6.38% $472,388 $17,198 7.34%
Taxable Investments 277,468 6,256 4.55% 250,838 6,846 5.50%
Federal Funds Sold and Securities Purchased
Under Agreements to Resell 15,731 108 1.38% 29,635 245 1.67%
---------------------------- ----------------------------
Total Interest Earning Assets $809,472 $22,709 5.66% $752,861 $24,289 6.51%
---------------------------- ----------------------------
Noninterest Earning Assets 50,928 50,651
-------- --------
Total Assets $860,400 $803,512
======== ========
INTEREST BEARING LIABILITIES
Interest Bearing Deposits:
Savings, NOW and Money Market Deposits $474,392 $ 1,686 0.72% $451,996 $ 2,849 1.27%
Time Deposits 193,953 2,417 2.51% 172,753 2,994 3.49%
---------------------------- ----------------------------
Total Savings and Time Deposits 668,345 4,103 1.24% 624,749 5,843 1.89%
---------------------------- ----------------------------
Federal Funds Purchased and Securities Sold
Under Agreements to Repurchase 16 -- 1.52% -- -- --
Short-Term Borrowings 1,520 13 1.72% 1,890 14 1.49%
Long-Term Debt 4,759 72 3.05% 2,423 41 3.41%
---------------------------- ----------------------------
Total Interest Bearing Liabilities 674,640 4,188 1.25% 629,062 5,898 1.89%
---------------------------- ----------------------------
Noninterest Bearing Deposits 93,063 90,577
Other Liabilities 8,857 6,699
Sotckholders' Equity 83,840 77,174
-------- -------
Total Liabilities and Stockholders' Equity $860,400 $803,512
======== ========
Net Earning Assets $134,832 $123,799
======== ========
Net Interest Income (Fully Taxable Equivalent) $18,521 $18,391
======= =======
Rate Spread 4.41% 4.62%
==== ====
Net Interest Margin 4.61% 4.93%
==== ====
Includes principal balance of non-accrual loans and fees on loans.
Excludes prepayment fees of $165 related to early payments by certain
loan customers in 2002.
11
Noninterest expenses: Total noninterest expense increased $761 thousand
from $7.05 million to $7.82 million for the second quarter of 2003 compared
to 2002, and by $1.23 million from $14.16 million to $15.39 million for the
first six months of the year. Merchants has continued its salary
administration project, which began with branch staff in 2002 and is
continuing with back office staff this year. Related salary increases are
being phased in over the course of 2003. The salary administration project
has contributed to the overall increase in salaries and employee benefits
of $380 thousand for the second quarter of this year and $636 thousand year
to date compared to last year. Additionally, Merchants is continuing to
experience increases in its pension plan expense. Although the pension plan
was curtailed in 1995, recent decreases in the market value of pension plan
assets have caused increased expense recognition. During the second quarter
of 2003 Merchants contributed $750 thousand to the pension plan. This
contribution was accounted for as a reduction to the minimum pension
liability, which is included in the other liabilities category in the
accompanying consolidated balance sheets.
Occupancy and Equipment expenses increased by $140 thousand for the second
quarter of 2003 compared to 2002, and by $203 thousand for the first six
months of 2003. This increase is due to increased software maintenance
costs, and normal increases in building maintenance and rental expenses.
Merchants anticipates that there may be additional expense increases
related to its network server infrastructure and desktop computer upgrade,
which is expected to be completed by the second quarter of 2004.
Approximately $200 thousand of the total estimated $2.07 million cost will
be expensed during 2003 and 2004, the balance of the cost of the project
will be capitalized and depreciated over three to five years. Merchants'
equity in losses of real estate limited partnerships increased $72 thousand
for the second quarter and $156 thousand for the first six months of 2003
compared to 2002 as Merchants continued to invest in community-based
affordable housing partnerships. Merchants finds these investments
attractive because they provide an opportunity for Merchants to invest in
affordable housing in the communities in which it does business, as well as
providing federal tax credits which are used as an offset to the income tax
provision.
Merchants' marketing expenses increased by $96 thousand for the second
quarter of 2003 compared to 2002 and by $147 thousand for the first six
months of the year as Merchants has continued to aggressively market its
premier product, Free Checking for Life(R), and to prepare for its entry
into two new markets during 2003. Sales of Free Checking for Life(R),
continue to be strong, and average balances in Free Checking for Life(R)
accounts increased from $89 million for the month of June 30, 2002, to $109
million for the month of June 30, 2003, a 22% increase. Merchants' St.
Albans, VT, branch, which opened in a temporary location in April 2003, is
one of the top five sales branches based on average weekly sales. Merchants
expects to occupy its permanent St. Albans location during the fourth
quarter of 2003 and plans to open its new location in White River Junction,
VT, during the third quarter of 2003.
Balance Sheet Analysis
Second quarter 2003 growth in average deposits and loans over the second
quarter of last year were 7.2% and 13.2% respectively. Quarter-end loan
balances were $540.7 million, an increase of $45.1 million over year-end
loan balances, and an annualized growth rate of 18.2%. Merchants has seen a
significant increase in loan demand for the first six months of this year.
Residential mortgage activity has been very high during 2003, as mortgage
rates have dropped to their lowest level in 40 years. Merchants has had
great success with its new 10-year fully amortizing mortgage product
RealLYNX-10(r), introduced in January 2003. This product was originally
introduced at a 4.95% rate, and was lowered to 4.65% for the months of June
and July. Through the first week of August 2003 Merchants has closed $49
million in new balances in this product and has over $20.8 million in
applications currently in process; contributing to total net new growth in
residential real estate for the first six months of the year of $33
million. Additionally, commercial loan activity has been strong as a result
of Merchants' active calling program. Commercial real estate outstanding
balances have increased by over $13 million since year end.
The following table summarizes the components of Merchants loan portfolio
as of June 30, 2003, and December 31, 2002.
(In thousands) June 30, 2003 December 31, 2002
----------------------------------------------------------------------------------
Commercial, Financial And Agricultural Loans $ 92,092 $ 93,856
Real Estate Loans - Residential 239,322 206,231
Real Estate Loans - Commercial 192,456 179,156
Real Estate Loans - Construction 8,613 9,154
Installment Loans 6,459 6,663
All Other Loans 1,728 528
------------------------------------------------------------------------------
Total Loans $540,670 $495,588
==============================================================================
12
Quarter-end deposits were $789.4 million, an increase of $34.2 million over
year-end deposit balances, and an annualized growth rate of 9.0%. Average
deposits for the second quarter of 2003 were $771.4 million, an increase of
$52.1 million over average deposits for the second quarter of 2002.
Merchants has redeployed excess funds into the investment portfolio which,
at June 30, 2003, was $298.9 million, compared to $273.4 million at June
30, 2002, and $270.2 million at December 31, 2002. Merchants plans to
continue to expand the investment portfolio over the course of 2003.
Merchants continues to work to enhance yield and minimize risk by
diversifying the investment portfolio while keeping the effective duration
of the investment portfolio at or below 2.5 years.
In the ordinary course of business, Merchants makes commitments for
possible future extensions of credit. On June 30, 2003, Merchants was
obligated to fund $6.4 million of standby letters of credit. No losses are
anticipated in connection with these commitments.
Income Taxes
Merchants and its subsidiaries are taxed on income by the Internal Revenue
Service at the federal level. The State of Vermont levies franchise taxes
on banks based upon average deposit levels in lieu of taxing income.
Franchise taxes are included in non-interest expenses in the consolidated
statements of operations.
Total income tax expense was $2.18 million for the first six months of
2003, compared to $2.28 million for the same period in 2002. Merchants
recognized favorable tax benefits of $330 thousand for the first six months
of 2003, compared to $342 thousand for the same period in 2002,
representing the amount of the federal tax credits earned during those
periods. Merchants' statutory tax rate was 35% for all periods. The
recognition of low income housing tax credits has contributed to Merchants'
effective tax rate of 27% for the first six months of 2003.
Liquidity and Capital Resources
Liquidity, as it pertains to banking, can be defined as the ability to
generate cash in the most economical way to satisfy loan demand, deposit
withdrawal demand, and to meet other business opportunities which require
cash. Merchants has a number of sources of liquid funds; including $25
million in available Federal Funds lines of credit at June 30, 2003; an
overnight line of credit with the Federal Home Loan Bank ("FHLB") of $15
million; an estimated additional borrowing capacity with FHLB of $121
million; and the ability to borrow $60 million through the use of
repurchase agreements, collateralized by Merchants' investments, with
certain approved counterparties. Merchants' investment portfolio, which
totaled $298.9 million at June 30, 2003, is managed by Merchants' Asset /
Liability Committee and is a strong source of cash flow for Merchants.
As of June 30, 2003, Merchants exceeded all applicable regulatory capital
requirements. The following table represents the actual capital ratios and
capital adequacy requirements for Merchants as of June 30, 2003 and 2002:
For Capital
Actual Adequacy Purposes
(In thousands) Amount Percent Amount Percent
- -----------------------------------------------------------------------
As of June 30, 2003
Merchants Bancshares, Inc.:
Tier 1 Risk-Based Capital $80,206 13.33% $24,062 4.00%
Total Risk-Based Capital 87,730 14.58% 48,124 8.00%
Tier 1 Leverage Capital 80,206 9.21% 34,817 4.00%
As of June 30, 2002
Merchants Bancshares, Inc.:
Tier 1 Risk-Based Capital $76,228 15.39% $19,813 4.00%
Total Risk-Based Capital 82,452 16.65% 39,626 8.00%
Tier 1 Leverage Capital 76,228 9.51% 32,176 4.00%
Non-Performing Assets and the Allowance for Loan Losses
Stringent credit quality is a major strategic focus of Merchants. Although
Merchants has been successful to date in minimizing its problem assets,
there is no assurance that Merchants will not have increased levels of
problem assets in the future, particularly in light of current or future
economic conditions.
13
The following table summarizes Merchants' non-performing assets as of June
30, 2003, March 31, 2003, December 31, 2002, and June 30, 2002:
(In thousands) June 30, 2003 March 31, 2003 December 31, 2002 June 30, 2002
- -----------------------------------------------------------------------------------------------------------------
Nonaccrual Loans $4,085 $2,858 $1,925 $2,067
Loans Past Due 90 Days or More and
Still Accruing 32 89 46 133
Restructured Loans 201 1,737 1,728 190
- ------------------------------------------------------------------------------------------------------------
Total Non-performing Loans ("NPL") 4,318 4,684 3,699 2,390
Other Real Estate Owned ("OREO") -- 57 57 353
- ------------------------------------------------------------------------------------------------------------
Total Non-performing Assets ("NPA") $4,318 $4,741 $3,756 $2,743
============================================================================================================
Non-performing assets have increased over the last year. This increase is
clearly reflective of a weak local and national economy, which, if it
continues, may contribute to further increases in levels of non-performing
assets. The individual components of the non-performing asset portfolio
remain fluid with the total maintained at a manageable and modest level.
Total NPL decreased $366 thousand from March 31, 2003 to June 30, 2003.
During the quarter a $1.5 million reduction in restructured loans was
offset in part by a $1.2 million increase in nonaccrual loans.
Approximately $1.1 million of the net increase in nonaccrual loans was
attributable to a transfer of loans that were previously classified as
restructured. This transfer was driven primarily by further deterioration
in the financial condition of one borrower. During the quarter a charge-off
of $363 thousand was taken on this borrower and the balance was moved to
nonaccrual. Total additions to nonaccrual loans from March 31, 2003 to June
30, 2003 were almost $2.5 million, including the transfers from
restructured loans. These increases in nonaccrual loans were offset in part
by $125 thousand in loans that were transferred back to accrual status,
$502 thousand in payments and $602 thousand in charges to the Allowance for
Loan Losses ("Allowance").
As of June 30, 2003, approximately $936 thousand of the loans listed as
non-performing were secured by cash and marketable securities. In addition,
guarantees from the Unites States Small Business Administration covered
approximately $1.1 million of the remaining nonaccrual loans.
Loans past due 90 days or more and still accruing interest decreased $57
thousand during the second quarter of 2003. Merchants did not have any OREO
as of June 30, 2003.
Early in July 2003 Merchants reached an agreement to sell approximately
$2.1 million in sub-performing and non-performing loans. The sale closed on
July 30, 2003. Total reductions in non-performing loans related to the sale
were approximately $900 thousand. Merchants recognized a small net recovery
on the sale.
The following table summarizes year-to-date activity in Merchants'
Allowance through the dates indicated:
(In thousands) June 30, 2003 March 31, 2003 December 31, 2002 June 30, 2002
- --------------------------------------------------------------------------------------------------------------
Allowance Beginning of Year $8,497 $8,497 $8,815 $8,815
Charge-Offs :
Commercial, Lease Financing
and all Other Loans (590) (39) (311) (11)
Real Estate - Mortgage (82) (2) (7) (6)
Installment & Other (9) (8) -- (3)
- ----------------------------------------------------------------------------------------------------------
Total Loans Charged Off (681) (49) (318) (20)
- ----------------------------------------------------------------------------------------------------------
Recoveries:
Commercial, Lease Financing
and all Other Loans 20 13 755 439
Real Estate - Mortgage 49 19 187 175
Installment & Other 2 -- 3 --
- ----------------------------------------------------------------------------------------------------------
Total Recoveries 71 32 945 614
- ----------------------------------------------------------------------------------------------------------
Net Loan Recoveries (Charge-Offs) (610) (17) 627 594
- ----------------------------------------------------------------------------------------------------------
Provision for Loan Losses -- -- (945) (614)
- ----------------------------------------------------------------------------------------------------------
Allowance End of Period $7,887 $8,480 $8,497 $8,795
==========================================================================================================
Charges to the Allowance were significantly higher than the first quarter
of 2003 as management elected to recognize $538 thousand of charges against
loans that previously received an allocation from the general reserve. The
net result did not have
14
any impact on the adequacy of the Allowance. Management does not anticipate
that the increased charges represent the beginning of an increase in
charge-off activity, or signal a decline in overall asset quality.
The Allowance is based on management's estimate of the amount required to
reflect the risks in the loan portfolio, based on circumstances and
conditions at each reporting date. Merchants reviews the adequacy of the
Allowance at least quarterly. Factors considered in evaluating the adequacy
of the Allowance include previous loss experience, current economic
conditions and their effect on the borrowers, the performance of individual
loans in relation to contract terms and estimated fair values of properties
to be foreclosed. The method used in determining the amount of the
Allowance is not based on maintaining a specific percentage of Allowance to
total loans or total NPA. Rather, the methodology is a comprehensive
analytical process of assessing the credit risk inherent in the loan
portfolio. This assessment incorporates a broad range of factors, which
indicate both general, and specific credit risk, as well as a consistent
methodology for quantifying probable credit losses. Losses are charged
against the Allowance when management believes that the collectibility of
principal is doubtful. To the extent management determines the level of
anticipated losses in the portfolio has significantly increased or
diminished, the Allowance is adjusted through current earnings. As part of
Merchants' analysis of specific credit risk, detailed and extensive reviews
are done on larger credits and problematic credits identified on the
watched asset list, non-performing asset listings and internal credit
rating reports. An outside loan review firm examines Merchants' commercial
loan portfolio three times per year. Over the course of the year,
approximately 75% of commercial loan balances are reviewed, including all
relationships over $750 thousand and criticized and classified loans over
$500 thousand. Issues addressed by the loan review process include the
accuracy of Merchants' internal risk ratings system, loan quality, and
adequacy of the Allowance. Loans deemed impaired at June 30, 2003, totaled
$4.0 million, of this total $3.7 million are included as non-performing
assets in the table above. Impaired loans have been allocated $23 thousand
of the Allowance.
The Allowance level reflects management's current strategies and efforts to
maintain the Allowance at a level adequate to provide for loan losses based
on an evaluation of known and inherent risks in the loan portfolio. Among
the factors that management considers in establishing the level of the
Allowance are overall findings from an analysis of individual loans, the
overall risk characteristics and size of the loan portfolio, past credit
loss history, management's assessment of current economic and real estate
market conditions and estimates of the current value of the underlying
collateral. Management considered the balance of the Allowance adequate at
June 30, 2003.
The following table reflects Merchants' non-performing asset and coverage
ratios as of June 30, 2003, March 31, 2003, December 31, 2002, and June 30,
2002:
June 30, 2003 March 31, 2003 December 31, 2002 June 30,2002
- ------------------------------------------------------------------------------------------------------------
NPL to Total Loans 0.80% 0.91% 0.75% 0.50%
NPA to Total Loans plus OREO 0.80% 0.92% 0.76% 0.58%
Allowance for Loan Losses to
Total Loans 1.46% 1.64% 1.71% 1.85%
Allowance for Loan Losses to NPL 186% 181% 230% 368%
Allowance for Loan Losses to NPA 186% 179% 226% 321%
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
General
Management and the Board of Directors are committed to sound risk
management practices throughout the organization. Merchants has developed
and implemented a centralized risk management monitoring program. Risks
associated with Merchants' business activities and products are identified
and measured as to probability of occurrence and impact on Merchants (low,
moderate, or high), and the control or other activities in place to manage
those risks are identified and assessed. Periodically, department-level and
senior managers re-evaluate and report on the risk management processes for
which they are responsible. This documented program provides management
with a comprehensive framework for monitoring Merchants' risk profile from
a macro perspective, while also serving as a tool for assessing internal
controls over financial reporting as required under the Federal Deposit
Insurance Corporation Improvement Act of 1991 ("FDICIA"), and the Sarbanes
Oxley Act of 2002.
Market Risk
Market risk is the risk of loss in a financial instrument arising from
adverse changes in market rates and prices such as interest rates, foreign
currency exchange rates, commodity prices, and equity prices. Merchants'
primary market risk exposure is interest rate risk. An important component
of Merchants' asset and liability management process is the ongoing
monitoring and management of this risk, which is governed by established
policies that are reviewed and approved annually
15
by its Board of Directors. The Board of Directors delegates responsibility
for carrying out the asset and liability management policies to the
Asset/Liability Committee ("ALCO"). In this capacity the ALCO develops
guidelines and strategies impacting Merchants' asset and liability management
related activities based upon estimated market risk sensitivity, policy limits
and overall market interest rate levels and trends. Merchants has an outside
investment advisory firm which helps it identify opportunities for increased
yield, without significantly increasing risk, in the investment portfolio. The
firm specializes in stable value and fixed income portfolios, and has a
staff of investment professionals who research and track each bond. During
the course of the last year Merchants' position in corporate debt securities
has increased to $43 million. Management feels that opportunities for
increased yield, without taking on undue risk, exist in the corporate market.
Merchants currently limits its position in corporate debt securities to
approximately 50% of capital and generally purchases corporate securities with
a rating of A or above. Merchants has also invested $23 million in Commercial
Mortgage Backed Securities, another area management feels has the
opportunity for increased yield without taking on undue risk. The goal is
to enhance performance on an absolute and a risk-adjusted basis.
Interest Rate Risk
The ALCO is responsible for evaluating and managing the interest rate risk
which arises naturally from imbalances in repricing, maturity and cash flow
characteristics of Merchants' assets and liabilities. The ALCO is
responsible for ensuring that the Board of Directors receives accurate
information regarding Merchants' interest rate risk position at least
quarterly. The ALCO uses an outside consultant to perform rate shocks of
Merchants' balance sheet, and to perform a variety of other analyses. The
consultant's most recent review was as of May 31, 2003. At that time, because
of the current rate environment, the consultant modified the rate shock model
and modeled a 100 basis point decrease as well as a 200 basis point increase.
At that time the change in net interest income for the next 12 months from
Merchants' expected or "most likely" forecast was as follows:
Percent Change in
Rate Change Net Interest Income
--------------------------------------------
Up 200 basis points 2.43%
Down 100 basis points (2.88%)
The consultant also ran additional simulations, which modeled an upward
movement in rates with a flattening yield curve, and a simulation using
Merchants' current growth assumptions. These types of dynamic analyses give
the ALCO a more thorough understanding of how Merchants' balance sheet will
perform in a variety of rate environments.
The preceding sensitivity analysis does not represent Merchants' forecast
and should not be relied upon as being indicative of expected operating
results. These estimates are based upon numerous assumptions including
without limitation: the nature and timing of interest rate levels including
yield curve shape, prepayments on loans and securities, deposit run-off
rates, pricing decisions on loans and deposits and reinvestment/replacement
of asset and liability cash flows, among others. While assumptions are
developed based upon current economic and local market conditions,
Merchants cannot make any assurances as to the predictive nature of these
assumptions including how customer preferences or competitor influences
might change.
As market conditions vary from those assumed in the sensitivity analysis,
actual results will likely differ due to: the varying impact of changes in
the balances and mix of loans and deposits differing from those assumed,
the impact of possible off balance sheet hedging strategies, and other
internal/external variables. Furthermore, the sensitivity analysis does not
reflect all actions that ALCO might take in responding to or anticipating
changes in interest rates.
The model used to perform the balance sheet simulation assumes a parallel
shift of the yield curve over twelve months and reprices every interest-
bearing asset and liability on the Merchants' balance sheet. The model uses
contractual repricing dates for variable products, contractual maturities
for fixed rate products, and product-specific assumptions for deposits such
as Free Checking For Life(r) accounts and Money Market accounts which are
subject to repricing based on current market conditions. Investment
securities with call provisions are examined on an individual basis in each
rate environment to estimate the likelihood of a call. The model also
assumes that the rate at which certain mortgage related assets prepay will
vary as rates rise and fall, based on prepayment estimates derived from the
Office of Thrift Supervision Net Portfolio Value Model.
Credit Risk
A network of loan officers manages credit risk, with review by Merchants'
Credit Department and oversight by Merchants' Board of Directors. The Board
of Directors grants each loan officer the authority to originate loans on
behalf of Merchants
16
and establishes policies regarding loan portfolio diversification and loan
officer lending limits. Merchants' 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.
Merchants' policy is to discontinue the accrual of interest on loans when
scheduled payments become contractually past due 90 or more days and the
ultimate collectibility of principal or interest becomes doubtful.
ITEM 4. CONTROLS AND PROCEDURES
The principal executive officer, principal financial officer, and other
members of senior management of Merchants have evaluated the disclosure
controls and procedures of Merchants as of the end of the period covered by
this quarterly report. Based on this evaluation, Merchants has concluded
that the disclosure controls and procedures effectively ensure that
information required to be disclosed in Merchants' filings and submissions
with the Securities and Exchange Commission under the Exchange Act, is
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
Securities and Exchange Commission. In addition, Merchants has reviewed its
internal controls and there have been no significant changes in its
internal controls or in the other factors that could significantly affect
those controls subsequent to the date of its last evaluation.
17
MERCHANTS BANCSHARES, INC.
PART II
ITEM 1. LEGAL PROCEEDINGS
Merchants is involved in routine legal proceedings occurring in the
ordinary course of business, which in the aggregate are believed by
management to be immaterial to its financial condition and results of
operations
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
None
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Company held its Annual Meeting of Shareholders on Tuesday, April 29,
2003, for the purpose of electing three directors, Joseph L. Boutin, Peter
A. Bouyea and Charles A. Davis, to serve for three-year terms, and electing
one director, Lorilee A. Lawton to serve a two-year term. Mr. Boutin
received 5,441,265 votes for and 31,272 votes against, Mr. Bouyea received
5,443,288 votes for and 29,248 votes against, Mr. Davis received 5,346,545
votes for and 110,940 votes against, and Ms. Lawton received 5,443,683
votes for and 28,854 votes against. There were no abstentions. At the time
of the annual meeting there were 6,185,996 shares entitled to vote. Shares
voted either in person or by proxy totaled 5,472,537, or 88.47% of the
shares entitled to vote.
ITEM 5. OTHER INFORMATION
None
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
Exhibits:
31.1 - Certification of Chief Executive Officer of the Company Pursuant
to Securities Exchange Act Rules 13a-14 and 15d-14
31.2 - Certification of Chief Financial Officer of the Company Pursuant
to Securities Exchange Act Rules 13a-14 and 15d-14
32.1 - Certification of Chief Executive Officer of the Company pursuant
to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
32.2 - Certification of Chief Financial Officer of the Company pursuant
to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
Current Reports on Form 8-K
Merchants Bancshares, Inc. filed a Current Report on Form 8-K on
April 18, 2003, related to first quarter 2003 earnings release.
Merchants Bancshares, Inc. filed a Current Report on Form 8-KA on May
1, 2003, related to a technical correction to the April 18, 2003,
Form 8-K.
18
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/ Joseph L. Boutin
--------------------
Joseph L. Boutin
President &
Chief Executive Officer
/s/ Janet P. Spitler
--------------------
Janet P. Spitler
Chief Financial Officer &
Treasurer
August 14, 2003
---------------
Date
19