UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

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

For the fiscal year ended	December 31, 2009

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)
Registrant's telephone number, including area code:				(802) 658 - 3400
Securities registered pursuant to Section 12(b) of the Act:
Title of each class			Name of each exchange on which registered
Common Stock, par value $0.01 per share				The NASDAQ Stock Market, LLC.
Securities registered pursuant to Section 12(g) of the Act:
None
(Title of class)

Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
[   ] Yes     [X] No

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act
[   ] Yes     [X] No

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. [X] Yes     [   ] No

Indicate by check mark 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).
[   ] Yes     [   ] No

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [   ]

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, 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.

Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act).
[   ] Yes     [X] No

The aggregate market value of the registrant’s voting common stock held by non-affiliates was $107,309,395 as computed using the per share price, as reported on the NASDAQ, as of market close on June 30, 2009.

As of March 5, 2010, there were 5,847,908 shares of the registrant’s common stock, par value $0.01 per share, outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement to Shareholders for the Registrant’s Annual Meeting of Shareholders to be held on May 4, 2010 are incorporated herein by reference in Part III.

MERCHANTS BANCSHARES, INC. AND SUBSIDIARIES

2009 FORM 10-K ANNUAL REPORT

TABLE OF CONTENTS

*

The information required by Part III is incorporated herein by reference from Merchants’ Proxy Statement for the Annual Meeting of Shareholders to be held on May 4, 2010, including specifically the Nominating & Governance Committee report to be included therein.

**

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

FORWARD-LOOKING STATEMENTS

Except for the historical information contained herein, this Annual Report on Form 10-K of Merchants may contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”). When used, the words “anticipate,” “believe,” “estimate,” “expect,” “intend,” “may,” “might,” “plan,” “project,” “result,” “should,” “will” and similar expressions which do not relate solely to historical matters are intended to identify forward-looking statements. These statements include, among other things, statements regarding Merchants’ intent, belief or expectations with respect to economic conditions, trends affecting Merchants’ financial condition or results of operations, and Merchants’ exposure to market, interest rate and credit risk.

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, which are described in more detail in Section 1A—“Risk Factors” beginning on page 13 of this document.

PART I

ITEM 1—BUSINESS

GENERAL

Merchants Bancshares, Inc. (“Merchants”) is a bank holding company originally organized under Vermont law in 1983 (and subsequently reincorporated in Delaware) for the purposes of owning all of the outstanding capital stock of The Merchants Bank (“Merchants Bank”) and providing greater flexibility in helping Merchants Bank achieve its business objectives. Merchants Bank, which is Merchants’ primary subsidiary, is a Vermont commercial bank with 34 full-service banking offices.

Merchants Bank was organized in 1849 and assumed a national bank charter in 1865, becoming The Merchants National Bank of Burlington, Vermont. On September 6, 1974, The Merchants National Bank of Burlington converted its national charter to a Vermont state commercial bank charter, adopting The Merchants Bank. The name was shortened to Merchants Bank in 1995. As used herein the term “Merchants” shall mean Merchants Bancshares, Inc. and its subsidiaries unless otherwise noted or the context otherwise requires. As of December 31, 2009, Merchants operated the sole remaining statewide commercial banking operation in Vermont, with deposits totaling $1.04 billion, gross loans of $919 million, and total assets of $1.43 billion.

Merchants Trust Company, formerly a Vermont corporation chartered in 1870, was merged into the Bank effective September 30, 2009. This merger had no effect on the consolidated balance sheet or statement of operations of Merchants as the Trust Company was a wholly owned subsidiary of the Bank prior to the merger. Merchants’ Trust division offers investment management, financial planning and trustee services. Its investment program is a globally diversified asset allocation strategy with attention to managing risk while addressing client return objectives. Merchants’ Trust division utilizes diversified mutual fund managers who have been selected based on careful, in-depth research and due diligence. Its planning services cover a wide range of issues including retirement, estate planning, and asset protection solutions. As of December 31, 2009, this division had fiduciary responsibility for assets having a market value in excess of $385 million, of which more than $331 million constituted managed assets.

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

RETAIL SERVICES

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

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

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

Merchants introduced Cash Rewards Checking in 2008. This is a personal checking product that provides a cash back feature on all point of sale debit card transactions. The account pays interest and comes with a $10.00 per month fee. The fee is waived in any statement period during which combined average balances among checking and money market accounts total $5,000 or greater. Cash Rewards Checking provides for reduced charges when using non-Merchants ATMs. There is also a feature that provides free paper checks to customers maintaining balance thresholds required to avoid monthly fees.

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

Merchants’ primary retail deposit savings product is its money market account. The money market account pays interest at tiered levels beginning with the first dollar in the account, and fees are charged only under certain limited circumstances. The low minimum balance to open this account combined with the minimum average balance threshold to avoid monthly service charges makes this an attractive savings vehicle.

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

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

Each of Merchants’ 34 full-service banking offices is led by a branch president who has responsibility for the full range of retail and small business credit services. Merchants’ branch system is led by eleven Market Managers who serve in assigned geographies around the state. The Market Managers work with the Branch Presidents and branch staff to provide a full range of personal and small business banking services. Currently, most customer inquiries can be handled at any branch location. The branch serves as sales, service, and lending center. Branch personnel can explain various deposit options and open new accounts online via internal systems. Additionally, qualified branch staff have the ability to take loan applications, approve loans within defined approval limits, and to close consumer, mortgage and small business loans. Merchants also operates 42 ATMs throughout Vermont, with additional surcharge-free access to 37,000 ATMs worldwide available to customers via Merchants’ participation in the Allpoint network. Merchants maintains a customer call center with expanded hours of operation. Customer calls are answered by well-trained employees operating from Merchants’ Service Center in South Burlington.

Customer contact staff continue to build relationships with all of Merchants’ households via a communication process known as XSell. The ongoing introduction of mortgage and home equity options to existing deposit customers contributed to significant growth in the residential real estate portfolio. Financing is available for one-to-four-family residential mortgages, residential construction and seasonal dwelling mortgages. Merchants offers both fixed rate and adjustable rate mortgages for residential properties, and provides a unique two-way rate lock protection feature. Merchants currently holds and services all originated mortgages in its loan portfolio.

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

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COMMERCIAL SERVICES

Merchants’ corporate sales staff services the majority of commercial customers, which are primarily larger operating companies, real estate investors and developers. Corporate banking officers and corporate banking administrators provide commercial credit, deposit and cash management services throughout Vermont to customers requiring business credit above the prescribed authorities of the branch presidents. Merchants is adding structure and capacity in corporate banking and credit to grow market share. In February 2010 Merchants hired an experienced commercial lender who will manage the southern region of its corporate banking department. Additionally, the commercial credit function was expanded and enhanced with the addition of a new Manager of Commercial Credit.

Branch presidents are trained for small business loan origination and to serve deposit and cash management needs of small businesses. Merchants hired two experienced government banking officers during 2008, and added another member to the team in 2009. The government banking group provides depository, lending and other banking services to municipalities, school districts and other governmental authorities or agencies in Merchants’ service area.

Financing is available for business inventory, accounts receivable, fixed assets, real estate, working capital, and community development. Merchants offers installment loans, credits lines, time loans, construction loans irrevocable letters of credit, U.S. Small Business Administration guaranteed loans and USDA guaranteed loans.

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

Merchants offers a variety of commercial checking accounts. Commercial checking uses an earnings credit rate to help offset service charges. Merchants offers Rewards Checking for Business, a low cost checking account that is appropriate for all but high volume commercial deposit customers. Major features of the account include no monthly fee, 999 free items per month, and 1% cash back on debit card purchases. Merchants offers a business money market account as the savings vehicle for businesses. Merchants’ business money market account pays interest at tiered levels beginning with the first dollar in the account. Commercial customers can use a money market account as overdraft coverage for a checking account.

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

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

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

COMPETITION

Presently, there are 12 independent financial institutions headquartered in the State of Vermont. In addition, there are 10 regional or national banks that have operations in Vermont. Merchants Bank remains the only independent statewide bank headquartered in the State of Vermont. Of the companies headquartered outside Vermont, eight are located in New Hampshire, New York, Connecticut, Massachusetts or Ohio. Two other banking companies are owned by a parent headquartered outside of the United States (one in Canada and one in the United Kingdom).

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Merchants competes in Vermont for deposit and loan business not only with other commercial and savings banks, and savings and loan associations, but also with credit unions, and other non-bank financial providers. As of December 31, 2008, the most recently available information, there were more than 28 state or federally chartered credit unions operating in Vermont. As a bank holding company and state chartered commercial bank, Merchants is subject to extensive regulation and supervision, including, in many cases, regulation that limits the type and scope of its activities. The non-bank financial service providers that compete with Merchants may be subject to less restrictive regulation and supervision. Competition from nationally chartered banks, local institutions, and credit unions continues to be active.

Several smaller community banks and credit unions have continued their commitment to increase their footprints in Merchants’ markets. In a state that already has one of the nation’s highest branch-to-population ratios, it is necessary to have a very competitive product offering and exceptional service levels in order to compete effectively.

Prior to 2006, there was a significant increase in new lenders licensed to do business in Vermont. These companies offer business, home mortgage and consumer finance loans. From December 31, 2006 to December 31, 2008 (the most recently available data), the number of licensed lenders declined from 1,149 to 705. This development has benefitted Merchants Bank positively in the commercial loan and home mortgage business.

The fact that Merchants is a locally managed, independent bank contributed significantly to the growth in loans and deposits during 2009. Customers have cited the local management and decision-making as important considerations when choosing a bank. The fact that several national or regional competitors operate as branches of a much larger company influenced some portion of the market that wanted to bank locally. This differentiation became heightened with the sale of several independent companies during 2007.

During late 2008, Merchants started a dedicated group focused solely on municipal and government banking. This group contributed significantly to growth of loans and deposits during 2009. It is expected that this trend will continue into 2010 as the municipal and government banking group was expanded toward the end of 2009.

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

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

NUMBER OF EMPLOYEES

As of December 31, 2009, Merchants employed 286 full-time and 36 part-time employees representing a combined full-time equivalent complement of 304 employees.

Merchants maintains comprehensive employee benefits programs for employees, which provide major medical insurance, hospitalization, dental insurance, long-term and short-term disability insurance, life insurance and a 401(k) Plan. Merchants Bank believes that relations with its employees are good. Merchants was selected for the second year in a row as one of the best places to work in Vermont by Vermont Business Magazine. The designation was based on the answers to an anonymous survey of employees from around the company.

REGULATION AND SUPERVISION

General

As a bank holding company registered under the Bank Holding Company Act of 1956, as amended (the “BHCA”), Merchants is subject to extensive regulation and supervision by the Board of Governors of the Federal Reserve System. As a state-chartered commercial bank, Merchants Bank is subject to substantial regulation and supervision by the Federal Deposit Insurance Corporation (the “FDIC”) and by applicable Vermont regulatory agencies; particularly the Commissioner of Banking, Insurance, Securities and Health Care Administration of the State of Vermont (the “Commissioner”). To the extent that the following information describes statutory or regulatory provisions, it is qualified in its entirety by reference to those particular statutory provisions. Any change in applicable law or regulation may have a material effect on the business and prospects of Merchants. The following discussion of certain of the material elements of the regulatory framework applicable to banks and bank holding companies is not intended to be complete.

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Recent Market Developments

Certain segments of the financial services industry are facing challenges in the face of prolonged economic uncertainty. In some areas, dramatic declines in the housing market, increasing foreclosures and rising unemployment have resulted in significant write-downs of asset values by financial institutions, including government-sponsored entities and major commercial and investment banks. These write-downs have caused many financial institutions to seek additional capital; to merge with larger and stronger institutions; and, in some cases, to fail. The FDIC closed 140 banks during 2009 and has closed more than 25 banks through the first week of March 2010, compared to 25 bank closures for all of 2008. Merchants is fortunate that, to date, the markets it serves have been impacted to a lesser extent than many areas around the country. However, a prolonged recession and persistently adverse economic conditions would likely impact these markets over time, and have a negative impact upon Merchants’ financial condition and performance.

In response to the financial crises affecting the banking system and financial markets, there have been many announcements of Federal programs designed to purchase or insure assets from, provide equity capital to, and guarantee the liquidity of, the industry. There can be no assurance that government action will help stabilize the U.S. financial system and will not have unintended adverse consequences on Merchants.

Other Proposals

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

Financial Services Modernization

The Gramm-Leach-Bliley Act ("Gramm-Leach"), which significantly altered banking laws in the United States, was signed into law in 1999. Gramm-Leach enabled combinations among banks, securities firms and insurance companies beginning in 2000. As a result of Gramm-Leach, many of the depression-era laws which restricted these affiliations and other activities which may be engaged in by banks and bank holding companies were repealed. Under Gramm-Leach, bank holding companies are permitted to offer their customers virtually any type of service that is financial in nature or incidental thereto, including banking, securities underwriting, insurance (both underwriting and agency), and merchant banking.

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

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

Bank Holding Company Regulation

Although Merchants believes that it meets the qualifications to become a financial holding company under Gramm- Leach, it has not elected “financial holding company” status, but rather to retain its pre-Gramm-Leach bank holding company regulatory status for the present time. This means that Merchants can engage in those activities which are closely related to banking. Merchants is required by the BHCA to file an annual report and additional reports required with the FRB. The FRB also makes periodic inspections of Merchants and its subsidiaries.

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

Dividends

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

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

It is the policy of the FRB that banks and bank holding companies, respectively, should pay dividends only out of current earnings and only if, after paying such dividends, the bank or bank holding company would remain adequately capitalized. Federal banking regulators also have authority to prohibit banks and bank holding companies from paying dividends if they deem such payment to be an unsafe or unsound practice. In addition, it is the position of the FRB that a bank holding company is expected to act as a source of financial strength to its subsidiary banks.

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

Certain Transactions by Bank Holding Companies with their Affiliates

There are various statutory restrictions on the extent to which bank holding companies and their non-bank subsidiaries may borrow, obtain credit from or otherwise engage in “covered transactions” with their insured depository institution subsidiaries. An insured depository institution (and its subsidiaries) may not lend money to, or engage in covered transactions with, its non-depository institution affiliates if the aggregate amount of covered transactions outstanding involving the bank, plus the proposed transaction exceeds the following limits: (a) in the case of any one such affiliate, the aggregate amount of covered transactions of the insured depository institution and its subsidiaries cannot exceed 10% of the capital stock and surplus of the insured depository institution; and (b) in the case of all affiliates, the aggregate amount of covered transactions of the insured depository institution and its subsidiaries cannot exceed 20% of the capital stock and surplus of the insured depository institution. For this purpose, “covered transactions” are defined by statute to include a loan or extension of credit to an affiliate, a purchase of or investment in securities issued by an affiliate, a purchase of assets from an affiliate unless exempted by the FRB, the acceptance of securities issued by an affiliate as collateral for a loan or extension of credit to any person or company, or the issuance of a guarantee, acceptance or letter of credit on behalf of an affiliate. Covered transactions are also subject to certain collateral security requirements. Covered transactions as well as other types of transactions between a bank and a bank holding company must be on market terms and not otherwise unduly favorable to the holding company or an affiliate of the holding company. Moreover, Section 106 of the BHCA provides that, to further competition, a bank holding company and its subsidiaries are prohibited from engaging in certain tying arrangements in connection with any extension of credit, lease or sale of property of any kind, or furnishing of any service.

Regulation of the Bank

As an FDIC-insured state-chartered bank, Merchants Bank is subject to the supervision of and regulation by the Commissioner and the FDIC. This supervision and regulation is for the protection of depositors, the Deposit Insurance Fund (“DIF”), and consumers, and is not for the protection of Merchants’ stockholders. The prior approval of the FDIC and the Commissioner is required, among other things, for Merchants Bank to establish or relocate an additional branch office, assume deposits, or engage in any merger, consolidation, purchase or sale of all or substantially all of the assets of any bank.

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Capital Adequacy and Safety and Soundness

Regulatory Capital Requirements. The FRB and the FDIC have issued substantially similar risk-based and leverage capital guidelines applicable to United States banking organizations. In addition, these regulatory agencies may from time to time require that a banking organization maintain capital above the minimum levels, whether because of its financial condition or actual or anticipated growth.

The FRB risk-based guidelines define a three-tier capital framework. Tier 1 capital includes common shareholders’ equity and qualifying preferred stock, less goodwill and other adjustments. Tier 2 capital consists of preferred stock not qualifying as Tier 1 capital, mandatory convertible debt, limited amounts of subordinated debt, other qualifying term debt and the allowance for credit losses up to 1.25% of risk-weighted assets. Tier 3 capital includes subordinated debt that is unsecured, fully paid, has an original maturity of at least two years, is not redeemable before maturity without prior approval by the FRB and includes a lock-in clause precluding payment of either interest or principal if the payment would cause the issuing bank’s risk-based capital ratio to fall or remain below the required minimum. The sum of Tier 1 and Tier 2 capital less investments in unconsolidated subsidiaries represents qualifying total capital. Risk-based capital ratios are calculated by dividing Tier 1 and total capital by risk-weighted assets. Assets and off-balance sheet exposures are assigned to one of four categories of risk-weights, based primarily on relative credit risk. The minimum Tier 1 risk-based capital ratio is 4% and the minimum total risk-based capital ratio is 8%. As of December 31, 2009, Merchants’ Tier 1 risk-based capital ratio was 13.34% and its Total risk-based capital ratio was 14.60%.

The leverage ratio is determined by dividing Tier 1 capital by adjusted average total assets. Banking organizations must maintain a ratio of at least 5% to be classified as “well capitalized.” Merchants’ leverage ratio at December 31, 2009 was 7.67%.

The Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), among other things, identifies five capital categories for insured depository institutions (well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized) and requires the federal banking agencies (the “Agencies”) to implement systems for “prompt corrective action” for insured depository institutions that do not meet minimum capital requirements within such categories. FDICIA imposes progressively more restrictive constraints on operations, management and capital distributions, depending on the category in which an institution is classified. Failure to meet the capital guidelines could also subject a banking institution to capital raising requirements. An “undercapitalized” bank must develop a capital restoration plan and its parent holding company must guarantee that bank’s compliance with the plan. The liability of the parent holding company under any such guarantee is limited to the lesser of 5% of the bank’s assets at the time it became “undercapitalized” or the amount needed to comply with the plan. Furthermore, in the event of the bankruptcy of the parent holding company, such guarantee would take priority over the parent’s general unsecured creditors. In addition, FDICIA requires the Agencies to prescribe certain non-capital standards for safety and soundness relating generally to operations and management, asset quality and executive compensation, and permits regulatory action against a financial institution that does not meet such standards.

The Agencies have adopted substantially similar regulations that define the five capital categories identified by FDICIA, using the total risk-based capital, Tier 1 risk-based capital and leverage capital ratios as the relevant capital measures. Such regulations establish various degrees of corrective action to be taken when an institution is considered undercapitalized. Under the regulations, a bank generally shall be deemed to be:

•

“well capitalized” if it has a total risk based capital ratio of 10.0% or greater, has a Tier I risk based capital ratio of 6.0% or more, has a leverage ratio of 5.0% or greater and is not subject to any written agreement, order or capital directive or prompt corrective action directive;

•

“adequately capitalized” if it has a total risk based capital ratio of 8.0% or greater, a Tier I risk based capital ratio of 4.0% or more, and a leverage ratio of 4.0% or greater (3.0% under certain circumstances) and does not meet the definition of a “well capitalized bank”;

•

“undercapitalized” if it has a total risk based capital ratio that is less than 8.0%, a Tier I risk based capital ratio that is less than 4.0% or a leverage ratio that is less than 4.0% (3.0% under certain circumstances);

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“significantly undercapitalized” if it has a total risk based capital ratio that is less than 6.0%, a Tier I risk based capital ratio that is less than 3.0% or a leverage ratio that is less than 3.0%; and

•

“critically undercapitalized” if it has a ratio of tangible equity to total assets that is equal to or less than 2.0%.

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Regulators also must take into consideration: (1) concentrations of credit risk; (2) interest rate risk; and (3) risks from non-traditional activities, as well as an institution’s ability to manage those risks, when determining the adequacy of an institution’s capital. This evaluation will be made as a part of the institution’s regular safety and soundness examination. In addition, Merchants, and any bank with significant trading activity, must incorporate a measure for market risk into their regulatory capital calculations. Merchants is currently considered well-capitalized under all regulatory definitions.

An institution generally must file a written capital restoration plan which meets specified requirements with an appropriate FDIC regional director within 45 days of the date that the institution receives notice or is deemed to have notice that it is undercapitalized, significantly undercapitalized or critically undercapitalized. An institution, which is required to submit a capital restoration plan, must concurrently submit a performance guaranty by each company that controls the institution. A critically undercapitalized institution generally is to be placed in conservatorship or receivership within 90 days unless the FDIC formally determines that forbearance from such action would better protect the deposit insurance fund. Immediately upon becoming undercapitalized, an institution becomes subject to the provisions of Section 38 of the Federal Deposit Insurance Act (“FDIA”) that, among other things, (i) restrict payment of capital distributions and management fees, (ii) require that the FDIC monitor the condition of the institution and its efforts to restore its capital, (iii) require submission of a capital restoration plan, (iv) restrict the growth of the institution’s assets and (v) require prior regulatory approval of certain expansion proposals.

The Agencies issued a final rule entitled “Risk-Based Capital Standards: Advanced Capital Adequacy Framework - Basel II” (“Basel II”) which became effective on April 1, 2008 and core banks (the approximately 20 largest U.S. bank holding companies) were required to adopt a board-approved plan to implement Basel II by Oct. 1, 2008. Basel II will result in significant changes to the risk based capital standards for "core" banks subject to Basel II and other banks that elect to use such rules to calculate their risk-based capital requirements. In connection with Basel II, the Agencies published a joint notice of proposed rulemaking entitled "Risk-Based Capital Guidelines; Capital Adequacy Guidelines: Standardized Framework" on July 29, 2008 (the "Standardized Approach Proposal"). The Standardized Approach Proposal, if adopted by the Agencies, would provide all non-core banks with an optional framework, based upon the standardized approach under the international Basel II Accord, for calculating their risk-based capital requirements. Merchants does not expect to calculate its capital ratios under Basel II or in accordance with the Standardized Approach Proposal. Accordingly, Merchants is not yet in a position to determine the effect of such rules on its risk capital requirements.

Deposit Insurance. Substantially all of the deposits of Merchants Bank are insured up to applicable limits by the Deposit Insurance Fund (“DIF”) of the FDIC and are subject to deposit insurance assessments to maintain the DIF. The FDIA, as amended by the Federal Deposit Insurance Reform Act, requires the FDIC to set a ratio of deposit insurance reserves to estimated insured deposits—the designated reserve ratio (the “DRR”)—for a particular year within a range of 1.15% to 1.50%. On February 27, 2009, the FDIC extended to seven years the time within which the reserve ratio must be returned to 1.15%. The FDIC utilizes a risk-based assessment system that imposes insurance premiums based upon a risk matrix that takes into account a bank’s capital level and supervisory rating (“CAMELS rating”). On February 27, 2009, the FDIC introduced three possible adjustments to an institution’s initial base assessment rate: (1) a decrease of up to five basis points for long-term unsecured debt, including senior unsecured debt (other than debt guaranteed under the Temporary Liquidity Guarantee Program) and subordinated debt and, for small institutions, a portion of Tier 1 capital; (2) an increase not to exceed 50 percent of a institution’s assessment rate before the increase for secured liabilities in excess of 25 percent of domestic deposits; and (3) for non-Risk Category I institutions, an increase not to exceed 10 basis points for brokered deposits in excess of 10 percent of domestic deposits. Beginning April 1, 2009, the minimum annualized assessment rate for banks in the lowest risk category, such as Merchants Bank, was 7 basis points and the maximum annualized assessment rate was 24 basis points. Beginning January 1, 2011, the FDIC assessment rates will be increased by 3 basis points.

In November 2009, the FDIC issued a final rule that mandated that insured depository institutions prepay their quarterly risk-based assessments to the FDIC for the fourth quarter of 2009 and for all of 2010, 2011 and 2012 on December 31, 2009. Institutions recorded the entire amount of its prepayment as a prepaid expense. The prepaid assessments bear a zero percent risk weight for risk-based capital purposes. The prepaid assessment for Merchants Bank was calculated using its third quarter 2009 assessment rate. That assessment base will be adjusted quarterly with an estimated 5 percent annual growth in the assessment base through the end of 2012. The prepaid assessment rate for the fourth quarter of 2009 and for 2010 is based on Merchants’ total base assessment rate for the third quarter of 2009. Further, the prepaid assessment rate for 2011 and 2012 is equal to the adjusted third quarter 2009 total base assessment rate plus 3 basis points. As of December 31, 2009, and for each quarter thereafter, Merchants will record an expense for its regular quarterly assessment for the quarter and a corresponding credit to the prepaid assessment until the asset is exhausted. The FDIC will not refund or collect additional prepaid assessments because of a decrease or growth in deposits over the next three years. However, should the prepaid assessment not be exhausted after collection of the amount due on June 30, 2013, the remaining amount of the prepayment will be returned to the institution. FDIC deposit insurance has been temporarily increased from $100,000 to $250,000 per depositor through December 31, 2013.

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FDIC insurance expense totaled $1.96 million and $356 thousand in 2009 and 2008 respectively. The expense for 2009 includes the $630 thousand special assessment that was expensed during the second quarter of this year. FDIC insurance expense includes deposit insurance assessments and Financing Corporation (“FICO”) assessments related to outstanding FICO bonds. The FICO is a mixed-ownership government corporation established by the Competitive Equality Banking Act of 1987 whose sole purpose was to function as a financing vehicle for the now defunct Federal Savings & Loan Insurance Corporation.

Under the FDIA, the FDIC may terminate deposit insurance upon a finding that the institution has engaged in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC.

Safety and Soundness Standards. The FDIA requires the federal bank regulatory agencies to prescribe standards, by regulations or guidelines, relating to internal controls, information systems and internal audit systems, loan documentation, credit underwriting, interest rate risk exposure, asset growth, asset quality, earnings, stock valuation and compensation, fees and benefits, and such other operational and managerial standards as the agencies deem appropriate. Guidelines adopted by the federal bank regulatory agencies establish general standards relating to internal controls and information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth and compensation, fees and benefits. In general, the guidelines require, among other things, appropriate systems and practices to identify and manage the risk and exposures specified in the guidelines. The guidelines prohibit excessive compensation as an unsafe and unsound practice and describe compensation as excessive when the amounts paid are unreasonable or disproportionate to the services performed by an executive officer, employee, director or principal stockholder. In addition, the agencies adopted regulations that authorize, but do not require, an agency to order an institution that has been given notice by an agency that it is not satisfying any of such safety and soundness standards to submit a compliance plan. If, after being so notified, an institution fails to submit an acceptable compliance plan or fails in any material respect to implement an acceptable compliance plan, the agency must issue an order directing action to correct the deficiency and may issue an order directing other actions of the types to which an undercapitalized institution is subject under the “prompt corrective action” provisions of FDIA. See “Regulatory Capital Requirements” above. If an institution fails to comply with such an order, the agency may seek to enforce such order in judicial proceedings and to impose civil money penalties.

Temporary Liquidity Guarantee Program. Merchants Bank is participating in the FDIC’s Temporary Liquidity guarantee Program (“TLGP”), which consists of the Transaction Account Guarantee Program (“TAGP”) and the recently expired Debt Guarantee Program (“DGP”). Through the TAGP, the FDIC will provide unlimited deposit insurance coverage for all noninterest-bearing transaction accounts through June 30, 2010. Merchants is participating in the TAGP. Effective January 1, 2010, the fee for the TAGP was raised and adjusted to reflect the risk category assigned to the institution under the FDIC’s risk-based premium system. For institutions in the lowest risk category, such as Merchants, the annual assessment rate during the extension period is 15 basis points. This assessment rate will apply to any deposit amounts exceeding the existing deposit insurance limit of $250,000, as reported on the quarterly call report, in any noninterest-bearing transaction accounts, including any such amounts swept from a noninterest-bearing transaction account into a noninterest-bearing savings deposit account. This includes traditional noninterest-bearing checking accounts, certain types of attorney trust accounts and NOW accounts for which the interest rate does not exceed 0.50%.

Depositor Preference. The FDIA provides that, in the event of the “liquidation or other resolution” of an insured depository institution, the claims of depositors of the institution, including the claims of the FDIC as subrogee of insured depositors, and certain claims for administrative expenses of the FDIC as a receiver, will have priority over other general unsecured claims against the institution. If an insured depository institution fails, insured and uninsured depositors, along with the FDIC, will have priority in payment ahead of unsecured, non-deposit creditors, including depositors whose deposits are payable only outside of the United States and the parent bank holding company, with respect to any extensions of credit they have made to such insured depository institution.

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Conservatorship and Receivership Amendments

FDICIA authorizes the FDIC to appoint itself conservator or receiver for a state-chartered bank under certain circumstances and expands the grounds for appointment of a conservator or receiver for an insured depository institution to include:

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consent to such action by the board of directors of the institution;

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cessation of the institution’s status as an insured depository institution;

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the institution is undercapitalized and has no reasonable prospect of becoming adequately capitalized, or fails to become adequately capitalized when required to do so, or fails to timely submit an acceptable capital plan, or materially fails to implement an acceptable capital plan; and

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the institution is critically undercapitalized or otherwise has substantially insufficient capital.

FDICIA provides that an institution’s directors shall not be liable to its stockholders or creditors for acquiescing in or consenting to the appointment of the FDIC as receiver or conservator for, or as a supervisor in the acquisition of, the institution.

Real Estate Lending Standards

FDICIA requires the federal bank regulatory agencies to adopt uniform real estate lending standards. The FDIC has adopted regulations, which establish supervisory limitations on Loan-to-Value (“LTV”) ratios in real estate loans by FDIC-insured banks, including national banks. The regulations require banks to establish LTV ratio limitations within or below the prescribed uniform range of supervisory limits.

Activities and Investments of Insured State Banks

FDICIA provides that FDIC-insured state banks such as Merchants Bank may not engage as a principal, directly or through a subsidiary, in any activity that is not permissible for a national bank, unless the FDIC determines that the activity does not pose a significant risk to the insurance fund, and the bank is in compliance with its applicable capital standards. In addition, an insured state bank may not acquire or retain, directly or through a subsidiary, any equity investment of a type, or in an amount, that is not permissible for a national bank, unless such investments meet certain grandfather requirements.

Gramm-Leach includes a section of the FDIA governing subsidiaries of state banks that engage in “activities as principal that would only be permissible” for a national bank to conduct in a financial subsidiary. This provision permits state banks, to the extent permitted under state law, to engage in certain new activities, which are permissible for subsidiaries of a financial holding company. See “Supervision and Regulation - Regulation of the Company.” Further, it expressly preserves the ability of a state bank to retain all existing subsidiaries. Because the applicable Vermont statute explicitly permits banks chartered by the state to engage in all activities permissible for national banks, Merchants Bank will be permitted to form subsidiaries to engage in the activities authorized by Gramm-Leach. In order to form a financial subsidiary, a state bank must be well-capitalized, and the state bank would be subject to certain capital deduction, risk management and affiliate transaction rules, which are applicable to national banks.

Consumer Protection Provisions

FDICIA also includes provisions requiring advance notice to regulators and customers for any proposed branch closing and authorizing (subject to future appropriation of the necessary funds) reduced insurance assessments for institutions offering “lifeline” banking accounts or engaged in lending in distressed communities. FDICIA also includes provisions requiring depository institutions to make additional and uniform disclosures to depositors with respect to the rates of interest, fees and other terms applicable to consumer deposit accounts.

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Customer Information Security

The FDIC and other bank regulatory agencies have adopted guidelines for establishing standards for safeguarding nonpublic personal information about customers that implement provisions of Gramm-Leach, which establishes a comprehensive framework to permit affiliations among commercial banks, insurance companies, securities firms, and other financial service providers by revising and expanding the BHCA framework. Specifically, the Information Security Guidelines established by Gramm-Leach require each financial institution, under the supervision and ongoing oversight of its board of directors or an appropriate committee of the board, to develop, implement and maintain a comprehensive written information security program designed to ensure the security and confidentiality of customer information, to protect against anticipated threats or hazards to the security or integrity of such information; and to protect against unauthorized access to or use of such information that could result in substantial harm or inconvenience to any customer. The federal banking regulators have issued guidance for banks on response programs for unauthorized access to customer information. This guidance, among other things, requires notice to be sent to customers whose “sensitive information” has been compromised if unauthorized use of this information is “reasonably possible.” Most states have enacted legislation concerning breaches of data security and Congress continues to consider federal legislation that would require that notice be sent to consumers of a data security breach.

Privacy

Gramm-Leach requires financial institutions to implement policies and procedures regarding the disclosure of nonpublic personal information about consumers to nonaffiliated third parties. In general, the statute requires financial institutions to explain to consumers their policies and procedures regarding the disclosure of such nonpublic personal information, and, unless otherwise required or permitted by law, financial institutions are prohibited from disclosing such information except as provided in their policies and procedures.

Regulatory Enforcement Authority

The enforcement powers available to the Agencies include, among other things, the ability to assess civil money penalties, to issue cease and desist or removal orders and to initiate injunctive actions against banking organizations and institution-affiliated parties, as defined. In general, these enforcement actions may be initiated for violations of law and regulations and unsafe or unsound practices. Other actions or inactions may provide the basis for enforcement action, including misleading or untimely reports filed with regulatory authorities. Under certain circumstances, federal and state law requires public disclosure and reports of certain criminal offenses and also final enforcement actions by the Agencies.

Identity Theft Red Flags

The Agencies jointly issued final rules and guidelines in 2007 implementing Section 114 (“Section 114”) of the Fair and Accurate Credit Transactions Act of 2003 (“FACT Act”) and final rules implementing section 315 of the FACT Act (“Section 315”). Section 114 requires Merchants to develop and implement a written Identity Theft Prevention Program (the “Program”) to detect, prevent, and mitigate identity theft in connection with the opening of certain accounts or certain existing accounts. Section 114 also requires credit and debit card issuers, such as Merchants, to assess the validity of notifications of changes of address under certain circumstances. The Agencies issued joint rules under Section 315 that provide guidance regarding reasonable policies and procedures that a user of consumer reports, such as Merchants, must employ when a consumer reporting agency sends the user a notice of address discrepancy. Merchants was compliant with these rules effective November 1, 2008.

Fair Credit Reporting Affiliate Marketing Regulations

In 2007, the Agencies published final rules to implement the affiliate marketing provisions in Section 214 of the FACT Act, which amends the Fair Credit Reporting Act. The final rules generally prohibit a person from using information received from an affiliate to make a solicitation for marketing purposes to a consumer, unless the consumer is given notice and a reasonable opportunity and a reasonable and simple method to opt out of the making of such solicitations. These rules became effective on January 1, 2008 and Merchants had to begin complying with the rules by October 1, 2008.

Community Reinvestment Act (“CRA”)

Pursuant to the CRA and similar provisions of Vermont law, regulatory authorities review the performance of Merchants in meeting the credit needs of the communities it serves. The applicable regulatory authorities consider compliance with this law in connection with the applications for, among other things, approval for de novo branches, branch relocations and acquisitions of banks and bank holding companies. Merchants Bank received a “satisfactory” rating at its 2008 CRA examination dated October 14, 2008, its most recent exam.

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Failure of an institution to receive at least a “Satisfactory” rating could inhibit such institution or its holding company from undertaking certain activities, including engaging in activities newly permitted as a financial holding company under Gramm-Leach, and acquisitions of other financial institutions. The FRB must take into account the record of performance of banks in meeting the credit needs of the entire community served, including low- and moderate-income neighborhoods. Current CRA regulations for large banks primarily rely on objective criteria of the performance of institutions under three key assessment tests: a lending test, a service test and an investment test. For smaller banks, current CRA regulations primarily evaluate the performance of institutions under two key assessment tests: a lending test and a community development test. Merchants is committed to meeting the existing or anticipated credit needs of its entire community, including low- and moderate-income neighborhoods, consistent with safe and sound banking operations.

Interstate Banking Act

The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, as amended (the "Interstate Banking Act"), generally permits adequately or well-capitalized bank holding companies to acquire banks in any state, and preempts all state laws restricting the ownership by a bank holding company of banks in more than one state. The Interstate Banking Act also permits a bank to merge with an out-of-state bank and convert any offices into branches of the resulting bank if both states have not opted out of interstate branching; permits a bank to acquire branches from an out-of-state bank if the law of the state where the branches are located permits the interstate branch acquisition; and permits banks to establish and operate de novo interstate branches whenever the host state opts-in to de novo branching. Bank holding companies and banks seeking to engage in transactions authorized by the Interstate Banking Act must be adequately capitalized and managed, and are required to obtain prior FRB approval to acquire more than 5% of a class of voting securities, or substantially all of the assets, of a bank holding company, bank or savings association.

USA Patriot Act

Under Title III of the USA Patriot Act, all financial institutions are required in general to identify their customers, adopt formal and comprehensive anti-money laundering programs, scrutinize or prohibit altogether certain transactions of special concern, and be prepared to respond to inquiries from U.S. law enforcement agencies concerning their customers and their transactions. Additional information-sharing among financial institutions, regulators, and law enforcement authorities is encouraged by the presence of an exemption from the privacy provisions of Gramm-Leach for financial institutions that comply with this provision and the authorization of the Secretary of the Treasury to adopt rules to further encourage cooperation and information-sharing. The effectiveness of a financial institution in combating money laundering activities is a factor to be considered in any application submitted by the financial institution under the Bank Merger Act and BHCA. Management believes that Merchants is in compliance with all requirements prescribed by the USA Patriot Act and all applicable final implementing regulations.

Sarbanes-Oxley Act of 2002

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

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

Federal Home Loan Bank System

Merchants Bank is a member of the Federal Home Loan Bank System, which consists of 12 regional Federal Home Loan Banks. The Federal Home Loan Bank (“FHLB”) provides a central credit facility primarily for member institutions. Member institutions are required to acquire and hold shares of capital stock in the FHLB in an amount at least equal to the sum of 0.35% of the aggregate principal amount of its unpaid residential mortgage loans and similar obligations at the beginning of each year and 4.5% of its advances (borrowings) from the FHLB. Merchants Bank was in compliance with this requirement with an investment in FHLB stock at December 31, 2009 of $8.63 million. At December 31, 2009, Merchants Bank had approximately $31.21 million in FHLB advances.

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In early 2009, due to deterioration in its financial condition, the Federal Home Loan Bank of Boston (“FHLBB”) placed a moratorium on redemption of stock in excess of required levels of ownership and suspended payment of quarterly dividends on its stock. No dividend income on FHLBB stock was recorded during 2009 and no dividend income on FHLBB stock is expected during 2010. FHLBB announced a $186.80 million net loss for 2009. The loss was primarily driven by losses due to the other-than-temporary-impairment (“OTTI”) of its investment in private label MBS resulting in a credit loss of $444.10 million for 2009. FHLBB continues to be classified as “adequately capitalized” by its primary regulator. Based on current available information, Merchants does not believe that its investment in FHLBB stock is impaired. Merchants will continue to monitor its investment in FHLBB stock.

Available Information

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

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

ITEM 1A—RISK FACTORS

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Adverse changes in economic conditions could impair our financial condition and results of operations. Merchants is impacted by general business and economic conditions in the United States and, to a lesser extent, abroad. These conditions include short-term and long-term interest rates, inflation, money supply, political issues, legislative and regulatory changes, fluctuations in both debt and equity capital markets, broad trends in industry and finance, unemployment and the strength of the U.S. economy and the local economies in which Merchants operates, all of which are beyond Merchants’ control. Deterioration in economic conditions could result in an increase in loan delinquencies, and non-performing assets, decreases in loan collateral values and a decrease in demand for Merchants’ products and services.

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The banking business is highly regulated, and Merchants may be adversely affected by changes in law and regulation. Merchants, primarily through Merchants Bank, is subject to extensive government regulation and supervision. Banking regulations are primarily intended to protect depositors’ funds, federal deposit insurance funds and the banking system as a whole, not shareholders. These regulations affect Merchants’ lending practices, capital structure, investment practices, dividend policy and growth, among other things. Congress and federal regulatory agencies continually review banking laws, regulations and policies for possible changes. Changes to statutes, regulations or regulatory policies, including changes in interpretation or implementation of statutes, regulations or policies, could affect Merchants in substantial and unpredictable ways. Such changes could subject Merchants to additional costs, limit the types of financial services and products Merchants may offer and/or increase the ability of non-banks to offer competing financial services and products, among other things. Failure to comply with laws, regulations or policies could result in sanctions by regulatory agencies, civil money penalties and/or reputation damage, which could have a material adverse effect on Merchants’ business, financial condition and results of operations. While Merchants has policies and procedures designed to prevent any such violations, there can be no assurance that such violations will not occur. See the section captioned “Regulation and Supervision” in Item 1 of this report for further information.

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There can be no assurance that government action will help stabilize the U.S. financial system and will not have unintended adverse consequences on Merchants. There can be no assurance as to what impact current and future government action and legislation will have on the financial markets. The failure of the U.S. government to execute programs intended to support the financial markets expeditiously could have a material adverse effect on the financial markets, which in turn could materially and adversely affect Merchants’ business, financial condition and results of operations. Merchants has faced increased regulation of its industry, compliance with which will increase Merchants’ costs and may limit its ability to pursue business opportunities. Also, participation in specific government programs intended to support banks may subject Merchants to additional restrictions. The effects of participating or not participating in any such programs cannot reliably be determined at this time.

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If Merchants’ allowance for loan losses is not adequate to cover actual loan losses, its earnings could decrease. Sustained declines in housing activity including declines in building permits, housing starts and home prices have made it more difficult for our borrowers to sell their homes or refinance their debt. Sales have slowed, which has strained the resources of real estate developers and builders. The current economic uncertainty has affected employment levels and has impacted the ability of some of Merchants’ borrowers to service their debt. Bank regulatory agencies periodically review Merchants’ allowance for credit losses and may require an increase in the provision for credit losses or the recognition of further loan charge-offs, based on judgments different than those of management. In addition, if charge-offs in future periods exceed the allowance for credit losses, Merchants will need additional provisions to increase the allowance for credit losses. Any increases in the allowance for credit losses will result in a decrease in net income and, possibly, capital, and may have a material adverse effect on Merchants’ financial condition and results of operations. Merchants may suffer higher loan losses as a result of these factors and the resulting impact on its borrowers.

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If market conditions worsen, the fair value of Merchants’ investment portfolio could be adversely affected and, in such case, certain unrealized losses could be designated as other than temporary in future periods which could result in a material charge to earnings and an adverse impact on Merchants’ capital ratios. Merchants worked to decrease its credit exposure in the investment portfolio during 2009, selling its entire commercial mortgage backed securities portfolio and several of its non-agency CMOs. Merchants, with the help of its investment advisor, has performed extensive analysis and stress testing on the remaining non-agency bonds in its investment portfolio. Merchants is closely tracking the performance of the underlying collateral on this portion of the portfolio.

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Merchants experiences strong competition within its markets, which may impact its profitability. Merchants’ success is dependent, notwithstanding the state’s perceived limited potential for growth, upon general economic conditions both globally and in Vermont and Vermont’s ability to attract, retain and grow new business. Merchants faces substantial competition in all areas of its operations from a variety of different competitors, many of which are larger and may have more financial resources. Such competitors primarily include national, regional, and community banks within the various markets in which Merchants operates. Merchants also faces competition from many other types of financial institutions, including, without limitation, savings and loans, credit unions, finance companies, brokerage firms, insurance companies, factoring companies and other financial intermediaries. The financial services industry could become even more competitive as a result of legislative, regulatory and technological changes and continued consolidation. Banks, securities firms and insurance companies can merge under the umbrella of a financial holding company, which can offer virtually any type of financial service, including banking, securities, underwriting, insurance (both agency and underwriting) and merchant banking. Also, technology has lowered barriers to entry and made it possible for non-banks to offer products and services traditionally provided by banks, such as automatic transfer and automatic payment systems. Many competitors have fewer regulatory constraints and may have lower cost structures. Additionally, due to their size, many competitors may be able to achieve economies of scale and, as a result, may offer a broader range of products and services than Merchants, as well as better pricing for those products and services.

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Interest rate volatility may reduce Merchants’ profitability. Merchants’ consolidated earnings and financial condition are primarily dependent upon net interest income, which is the difference between interest earned from loans and investments and interest paid on deposits and borrowings. The narrowing of interest rate spreads could adversely affect Merchants’ earnings and financial condition. Merchants cannot predict with certainty or control changes in interest rates. Regional and local economic conditions and the policies of regulatory authorities, including monetary policies of the Federal Reserve Board, affect interest income and interest expense. While Merchants has ongoing policies and procedures designed to manage the risks associated with changes in market interest rates, changes in interest rates still may have an adverse effect on Merchants’ profitability. The current steep yield curve provides opportunities for Merchants as a financial intermediary. If the yield curve should flatten Merchants’ net interest income could be negatively impacted. Increases in interest rates could affect the amount of loans that Merchants can originate, because higher rates could cause customers to apply for fewer mortgages, or cause depositors to shift funds from accounts that have a comparatively lower cost, to accounts with a higher cost or experience customer attrition due to competitor pricing. If the cost of interest-bearing deposits increases at a rate greater than the yields on interest-earning assets increase, net interest income will be negatively affected. Changes in the asset and liability mix may also affect net interest income. Similarly, lower interest rates cause higher yielding assets to prepay and floating or adjustable rate assets to reset to lower rates. If Merchants is not able to reduce its funding costs sufficiently, due to either competitive factors or the maturity schedule of existing liabilities, then Merchants’ net interest margin will decline.

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Merchants could experience a liquidity crisis. Under certain circumstances Merchants’ sources of liquidity could become stressed if customers withdraw their money from the financial system or Merchants’ other sources of liquidity become limited or unavailable.

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Merchants’ commercial, commercial real estate and construction loan portfolio may expose it to increased credit risks. At December 31, 2009, approximately 47% of Merchants’ loan portfolio was comprised of commercial, commercial real estate, and construction loans with some relationships exceeding $15 million dollars, exposing Merchants to the risks inherent in financings based upon analyses of credit risk, the value of underlying collateral, including real estate, and other more intangible factors, which are considered in making commercial loans. In general, commercial and commercial real estate loans historically pose greater credit risks, than owner occupied residential mortgage loans. The repayment of commercial real estate loans depends on the business and financial condition of borrowers, and a number of Merchants’ borrowers have more than one commercial real estate loan outstanding with Merchants. Further, these loans are concentrated primarily in Vermont. Economic events and changes in government regulations, which Merchants and its borrowers cannot control or reliably predict, could have an adverse impact on the cash flows generated by properties securing our commercial real estate loans and on the values of the properties securing those loans. Repayment of commercial loan depends substantially on the borrowers’ underlying business, financial condition and cash flows. Commercial loans are generally collateralized by equipment, leases, inventory, accounts receivable and other fixed assets. Compared to real estate, that type of collateral is more difficult to monitor, its value is harder to ascertain, it may depreciate more rapidly and it may not be as readily saleable if repossessed.

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Merchants’ loans are concentrated in Vermont, and adverse conditions in those markets could adversely affect Merchants’ operations. If real estate values in Merchants’ market decline or become stagnant, business could be adversely affected. At December 31, 2009, approximately 82% of Merchants’ loan portfolio was comprised of residential real estate and commercial real estate and construction loans, exposing Merchants to the risks inherent in financings based upon analyses of credit risk and the value of underlying collateral. Real estate prices in some parts of the country have steadily declined and activity in real estate construction and housing starts has declined significantly. These trends could ultimately impact the value and liquidity of the real estate or other collateral securing Merchants’ loans. Merchants’ profitability may be negatively impacted by errors in risk analyses, by loan defaults, and the ability of certain borrowers to repay such loans may be adversely affected by any downturn in general economic conditions.

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Merchants must adapt to information technology changes in the financial services industry, which could present operational issues, require significant capital spending, or impact Merchants’ reputation. The financial services industry is constantly undergoing technological changes, with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and reduce costs. Merchants’ future success will depend, in part, upon Merchants’ ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands for convenience, as well as to create additional efficiencies in Merchants’ operations. Merchants may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to Merchants’ customers.

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Risk of theft of customer information resulting from security breaches by third parties exposes Merchants to reputation risk and potential monetary loss. Merchants has exposure to fraudulent use of its customers’ personal information resulting from its general business operations and through customer use of financial instruments such as debit cards. While Merchants has policies and procedures designed to prevent or limit the effect of this risk, there can be no assurance that any such security breaches will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any security breaches could damage Merchants’ reputation, result in a loss of customer business, subject Merchants to additional regulatory scrutiny, or expose Merchants to civil litigation and possible financial liability, any of which could have a material adverse effect on Merchants’ financial condition and results of operations.

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Merchants evaluates acquisition and other expansion opportunities and strategies, the implementation of which could affect Merchants’ financial performance. To the extent that Merchants acquires other companies in the future, Merchants’ business may be negatively impacted by certain risks inherent with such acquisitions. These risks include the following:

o

the risk that the acquired business will not perform in accordance with Management’s expectations;

o

the risk that difficulties will arise in connection with the integration of the operations of the acquired business with the operations of Merchants’ businesses;

o

the risk that management will divert its attention from other aspects of Merchants’ business;

o

the risk that Merchants may lose key employees of the combined business; and

o

the risks associated with entering into geographic and product markets in which Merchants has limited or no direct prior experience.

•

The increase in FDIC deposit insurance premiums will increase Merchants’ non-interest expense. Beginning April 1, 2009, the minimum annualized assessment rate for Risk Category 1 institutions, which includes Merchants, was 7 basis points and the maximum annualized assessment rate was 24 basis points. Beginning January 1, 2011, the FDIC assessment rates will be increased by 3 basis points. In November 2009, the FDIC issued a final rule that mandated that insured depository institutions prepay their quarterly risk-based assessments to the FDIC for the fourth quarter of 2009 and for all of 2010, 2011 and 2012 on December 31, 2009. FDIC insurance expense totaled $1.96 million and $356 thousand in 2009 and 2008, respectively. There is no guarantee that the FDIC will not impose another special assessment or increase rates further than what has been announced.

•

Merchants may be unable to attract and retain key personnel. Merchants’ success depends, in large part, on its ability to attract and retain key personnel. Competition for qualified personnel in the financial services industry can be intense and Merchants’ may not be able to hire or retain the key personnel that it depends upon for success. The unexpected loss of services of one or more of Merchants’ key personnel could have a material adverse impact on its business because of their skills, knowledge of the markets in which Merchants operate, years of industry experience and the difficulty of promptly finding qualified replacement personnel.

These factors, as well as general economic and market conditions in the United States of America, fears of a global recession, and continued market turmoil and credit issues, may materially and adversely affect the market price of shares of Merchants’ common stock. Because of these and other factors, past financial performance should not be considered an indicator of future performance. The forward-looking statements contained herein represent Merchants’ judgment as of the date of this Form 10-K, and Merchants undertakes no duty to update these forward-looking statements. Merchants cautions readers not to place undue reliance on such statements.

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ITEM 1B—UNRESOLVED STAFF COMMENTS

Merchants has no unresolved comments from the SEC staff.

ITEM 2—PROPERTIES

Merchants made the decision during 2008 to close three of its branches, two were closed in 2008, and one more closed in 2009. One of the properties was sold in early 2009 for an amount in excess of its current net book value. During 2009, Merchants completely refurbished one of its facilities in the Burlington area, expanded a full service facility in the southern part of the state and also expanded one of its facilities in the southern part of the state to a full service branch. As of December 31, 2009, Merchants operated 34 full-service banking offices, and 42 ATMs throughout the state of Vermont. Merchants’ headquarters are located in Merchants’ Service Center at 275 Kennedy Drive, South Burlington, Vermont, which also houses Merchants’ operations and administrative offices and Merchants’ Trust division.

Merchants leases certain premises from third parties, including its headquarters, under current market terms and conditions. The offices of all subsidiaries are in good physical condition with modern equipment and facilities considered adequate to meet the banking needs of customers in the communities served. Additional information relating to Merchants’ properties is set forth in Note 4 to the consolidated financial statements included in Item 8 of this 2009 Annual Report on Form 10-K.

ITEM 3—LEGAL PROCEEDINGS

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

ITEM 4—[RESERVED]

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PART II

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

AND ISSUER PURCHASES OF EQUITY SECURITIES

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

Quarter Ended	High	Low	Dividends Paid
December 31, 2009	$25.00	$19.51	$0.28
September 30, 2009	26.48	21.22	0.28
June 30, 2009	24.02	17.59	0.28
March 31, 2009	20.95	16.89	0.28
December 31, 2008	24.45	17.00	0.28
September 30, 2008	24.25	18.00	0.28
June 30, 2008	24.12	22.22	0.28
March 31, 2008	24.49	21.50	0.28

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

Performance Graph

The line-graph presentation below compares cumulative five-year shareholder returns with the NASDAQ Banks and the Russell 2000 Index. The comparison assumes the investment, on 12/31/2004, of $100 in Merchants’ common stock and each of the foregoing indices and reinvestment of all dividends.

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

Securities Authorized for Issuance under Equity Compensation Plans

Merchants maintains equity compensation plans: the 2008 Deferred Compensation Plan for Non-Employee Directors and Trustees (the “deferred compensation plan”) and the Long Term Incentive/Stock Option Plan (the “stock option plan”). Each of these plans has been approved by Merchants’ stockholders. The following table includes information as of December 31, 2009 about these plans which provide for the issuance of common stock in connection with the exercise of stock options and other share-based awards.

Plan Category	Number of Securities to be Issued Upon Exercise of Outstanding Options, Warrants and Rights	Weighted Average Price of Outstanding Options, Warrants and Rights	Number of Securities Remaining Available for Future Issuance Under Equity Compensation Plans (Excluding Securities Reflected in First Column)
Equity Compensation Plans    Approved by Security Holders	81,071(a)	$23.30(b)	668,995
Equity Compensation Plans Not    Approved by Security Holders	--	--	--
Total	81,071	$23.30	668,995

(a)

This number does not include an aggregate of 326,453 shares then outstanding under the deferred compensation plan.

(b)

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

Purchases of Issuer Equity Securities by the Issuer

The following table provides information with respect to purchases Merchants made of its common stock during the three months ended December 31, 2009:

Period	Total Number of Shares Purchased	Average Price Paid per Share	Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs	Maximum Number of Shares that May Yet Be Purchased Under the Plans or Programs
October 1 – 31, 2009	--	--	--	56,525
November 1– 30, 2009	--	--	--	56,525
December 1 – 31, 2009	--	--	--	56,525
Total	--	--	--

In January 2007 Merchants’ Board of Directors approved a stock repurchase program, pursuant to which Merchants may repurchase 200,000 shares of its stock from time to time through January 2008. The program was extended by the Board at its meetings in January 2008, 2009 and 2010, and the program has now been extended to January 2011. Merchants has purchased 143,475 shares of its common stock on the open market under the program at an average per share price of $22.94. No shares were purchased during 2009 under the program.

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As of March 8, 2010, Merchants had 851 registered shareholders. Merchants declared and distributed dividends totaling $1.12 per share during 2009. In January 2010, Merchants declared a dividend of $0.28 per share, which was paid on February 18, 2010, to shareholders of record as of February 4, 2010. Future dividends will depend upon the financial condition and earnings of Merchants and its subsidiaries, its need for funds and other factors, including applicable government regulations.

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

ITEM 6—SELECTED FINANCIAL DATA

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

The following information should be analyzed in conjunction with Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations and with the audited consolidated financial statements included in Item 8 of this 2009 Annual Report on Form 10-K.

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Merchants Bancshares, Inc.

Five Year Summary of Financial Data

		At or For the Years Ended December 31,
(In thousands except share and per share data)			2009			2008			2007			2006			2005
Results for the Year
Interest and Dividend Income		$	66,340		$	68,582		$	64,599		$	61,997		$	53,809
Interest Expense			16,224			24,929			26,386			23,289			13,874
Net Interest Income			50,116			43,653			38,213			38,708			39,935
Provision for Loan Losses			4,100			1,525			1,150			--			--
Net Interest Income after Provision for Loan Losses			46,016			42,128			37,063			38,708			39,935
Noninterest Income			10,315			8,658			9,344			8,188			7,800
Noninterest Expense			40,098			35,101			32,288			32,724			32,082
Income before Income Taxes			16,233			15,685			14,119			14,172			15,653
Provision for Income Taxes			3,754			3,768			3,261			3,301			3,751
Net Income		$	12,479		$	11,917		$	10,858		$	10,871		$	11,902
Share Data
Basic Earnings per Common Share		$	2.04		$	1.96		$	1.77		$	1.73		$	1.88
Diluted Earnings per Common Share		$	2.04		$	1.96		$	1.76		$	1.73		$	1.87
Cash Dividends Declared per Common Share		$	1.12		$	1.12		$	1.12		$	1.12		$	1.08
Weighted Average Common Shares Outstanding (1)			6,105,909			6,069,653			6,148,494			6,275,709			6,318,524
Period End Common Shares Outstanding (2)			6,141,823			6,061,182			6,096,737			6,196,328			6,290,889
Year-end Book Value		$	15.65		$	13.89		$	13.05		$	11.87		$	11.11
Year-end Book Value (2)		$	14.82		$	13.15		$	12.35		$	11.25		$	10.55
Key Performance Ratios
Return on Average Shareholders' Equity			14.67	%		15.83	%		15.37	%		16.24	%		18.26	%
Return on Average Assets			0.91	%		0.93	%		0.96	%		0.98	%		1.13	%
Tier 1 Leverage Ratio			7.67	%		7.42	%		8.14	%		8.24	%		8.54	%
Tangible Equity Ratio			6.34	%		5.94	%		6.42	%		5.93	%		6.59	%
Allowance for Loan Loss to Total Loans at Year-end (3)			1.19	%		1.05	%		1.09	%		1.00	%		1.17	%
Nonperforming Loans as a Percentage of Total Loans			1.58	%		1.37	%		1.26	%		0.39	%		0.39	%
Net Interest Margin			3.80	%		3.58	%		3.56	%		3.69	%		4.03	%
Average Balances
Total Assets		$	1,376,441		$	1,277,242		$	1,131,588		$	1,110,701		$	1,053,861
Earning Assets			1,326,326			1,220,393			1,075,367			1,050,123			990,495
Gross Loans			901,582			781,645			713,119			648,713			589,408
Investments (4)			388,215			428,198			325,860			394,611			400,268
Total Deposits			1,003,778			923,863			873,674			857,022			843,952
Shareholders' Equity			85,093			75,303			70,661			66,959			65,179
At Year-End
Total Assets		$	1,435,248		$	1,341,210		$	1,170,743		$	1,136,958		$	1,075,236
Gross Loans			918,538			847,127			731,508			689,283			605,926
Allowance for Loan Losses (3)			10,976			8,894			8,002			6,911			7,083
Investments (4)			417,441			440,132			370,704			345,059			399,356
Total Deposits			1,043,319			930,797			867,437			877,352			854,576
Shareholders' Equity			91,012			79,697			75,307			69,697			66,397

(1)

Weighted average common shares outstanding includes an average of 317,288; 315,130; 319,357; 313,079; and 309,268 shares held in Rabbi Trusts for deferred compensation plans for directors for 2009, 2008, 2007, 2006, and 2005, respectively.

(2)

Period end common shares outstanding and this book value includes 326,453; 323,754; 325,789; 323,038; and 314,602 shares held in Rabbi Trusts for deferred compensation plans for directors for 2009, 2008, 2007, 2006, and 2005, respectively.

(3)

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

(4)

Includes Federal Home Loan Bank stock.

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Merchants Bancshares, Inc.

Summary of Quarterly Financial Information

(Unaudited)

(In thousands except per share data)	2009						2008
	Q4	Q3	Q2	Q1	Year		Q4	Q3	Q2	Q1	Year
Interest and Dividend Income	$16,013	$16,579	$16,713	$17,035	$66,340		$17,574	$17,617	$16,942	$16,449	$68,582
Interest Expense	3,309	3,883	4,338	4,694	16,224		5,475	6,191	6,452	6,811	24,929
Net Interest Income	12,704	12,696	12,375	12,341	50,116		12,099	11,426	10,490	9,638	43,653
Provision for Loan Losses	600	600	2,000	900	4,100		600	575	50	300	1,525
Noninterest Income	3,378	2,602	2,406	1,929	10,315		1,824	2,286	2,305	2,243	8,658
Noninterest Expense	10,418	9,803	10,335	9,542	40,098		9,244	8,783	8,950	8,124	35,101
Income before Income Taxes	5,064	4,895	2,446	3,828	16,233		4,079	4,354	3,795	3,457	15,685
Provision for Income Taxes	1,268	1,181	383	922	3,754		1,015	1,042	911	800	3,768
Net Income	$  3,796	$  3,714	$  2,063	$  2,906	$12,479		$  3,064	$  3,312	$  2,884	$  2,657	$11,917
Basic Earnings Per Share	$    0.62	$    0.61	$    0.34	$    0.48	$    2.04		$    0.51	$    0.55	$    0.48	$    0.44	$    1.96
Diluted Earnings Per Share	0.62	0.61	0.34	0.48	2.04		0.51	0.55	0.47	0.44	1.96
Cash Dividends Declared  and Paid Per Share	$    0.28	$    0.28	$    0.28	$    0.28	$    1.12		$    0.28	$    0.28	$    0.28	$    0.28	$    1.12

CRITICAL ACCOUNTING POLICIES

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

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

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

Income Taxes: Merchants estimates its income taxes for each period for which a statement of income is presented. This involves estimating Merchants’ actual current tax exposure, as well as assessing temporary differences resulting from differing timing of recognition of expenses, income and tax credits, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in Merchants’ consolidated balance sheets. Merchants must also assess the likelihood that any deferred tax assets will be recovered from future taxable income and, to the extent that recovery is not likely, a valuation allowance must be established. Significant management judgment is required in determining income tax expense, and deferred tax assets and liabilities. As of December 31, 2009 Merchants determined that no valuation allowance for deferred tax assets was necessary.

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Valuation of Investment Securities: Management evaluates securities for other-than-temporary impairment on at least a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. When an other-than-temporary impairment has occurred, the amount of the other-than-temporary impairment recognized in earnings depends on whether Merchants intends to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss. To determine whether an impairment is other-than-temporary, Merchants considers all available information relevant to the collectability of the security, including past events, current conditions, and reasonable and supportable forecasts when developing estimates of cash flows expected to be collected. Evidence considered in this assessment includes the reasons for the impairment, the severity and duration of the impairment, changes in value subsequent to year-end, forecasted performance of the investee, and the general market condition in the geographic area or industry the investee operates in.

If Merchants intends to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss, the other-than-temporary impairment is recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date. If Merchants does not intend to sell the security and it is not more likely than not that Merchants will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss, the other-than-temporary impairment is separated into the amount representing the credit loss and the amount related to all other factors. The amount of the total other-than-temporary impairment related to the credit loss is recognized in earnings. The amount of the total other-than-temporary impairment related to other factors is recognized in other comprehensive income, net of applicable income taxes.

GENERAL

The following discussion and analysis of financial condition and results of operations of Merchants and its subsidiaries for the three years ended December 31, 2009 should be read in conjunction with the Consolidated Financial Statements and Notes thereto and selected statistical information appearing elsewhere in this Form 10-K. The information about asset yields, interest rate spreads and net interest margins is discussed on a fully taxable equivalent basis. The financial condition and results of operations of Merchants essentially reflect the operations of its principal subsidiary, Merchants Bank. Certain statements contained in this section constitute “Forward-Looking Statements” and are subject to certain risks and uncertainties described in this 10-K under the heading “Forward-Looking Statements” and “Risk Factors”.

Recent Market Developments

Certain segments of the financial services industry are facing challenges in the face of prolonged economic uncertainty. In some areas, dramatic declines in the housing market, increasing foreclosures and rising unemployment have resulted in significant write-downs of asset values by financial institutions, including government-sponsored entities and major commercial and investment banks. These write-downs have caused many financial institutions to seek additional capital; to merge with larger and stronger institutions; and, in some cases, to fail. The FDIC closed 140 banks during 2009 and has closed more than 25 banks through the first week of March 2010, compared to 25 bank closures for all of 2008. Merchants is fortunate that, to date, the markets it serves have been impacted to a lesser extent than many areas around the country. However, a prolonged recession and persistently adverse economic conditions would likely impact these markets over time, and have a negative impact upon Merchants’ financial condition and performance.

In response to the financial crises affecting the banking system and financial markets, there have been many announcements of Federal programs designed to purchase or insure assets from, provide equity capital to, and guarantee the liquidity of, the industry. There can be no assurance that government action will help stabilize the U.S. financial system and will not have unintended adverse consequences on Merchants.

RESULTS OF OPERATIONS

Overview

Merchants realized net income of $12.48 million, $11.92 million, and $10.86 million for the years ended December 31, 2009, 2008 and 2007, respectively. Basic earnings per share were $2.04, $1.96, and $1.77 and diluted earnings per share were $2.04, $1.96, and $1.76 for the years ended December 31, 2009, 2008, and 2007, respectively. Merchants declared and distributed total dividends of $1.12 per share each year during 2009, 2008, and 2007, respectively. In January 2010, Merchants declared a dividend of $0.28 per share, which was paid on February 18, 2009, to shareholders of record as of February 4, 2009.

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Net income as a percentage of average equity capital was 14.67%, 15.83%, and 15.37%, for 2009, 2008, and 2007, respectively. Net income as a percentage of average assets was 0.91%, 0.93%, and 0.96%, for 2009, 2008, and 2007, respectively.

•

Net interest income - Merchants’ taxable equivalent net interest income increased $6.65 million to $50.38 million for 2009 compared to 2008, a 15.2% increase. Merchants’ taxable equivalent net interest margin increased to 3.80% from 3.58% over the same time period.

•

Provision for Credit Losses – The provision for credit losses was $4.10 million for 2009 compared to $1.53 million for 2008, reflecting increases in total loans combined with increased non-accruing and classified loans and net charge-offs, as well as a prolonged period of declining economic activity.

•

Loans - Loans ended 2009 at $918.54 million, a $71.41 million, or 8.4%, increase over 2008 ending balances.

•

Deposits - Merchants’ year-end deposit balances increased $112.52 million, or 12.1%, to $1.04 billion at December 31, 2009 from $930.80 million at December 31, 2008. All deposit categories grew over 2008 year end balances.

•

FHLB prepayment - Merchants prepaid a total of $60.63 million in FHLB debt during 2009, resulting in a $1.55 million prepayment penalty.

Net Interest Income

2009 compared with 2008

Merchants’ taxable equivalent net interest income increased $6.65 million to $50.38 million for 2009 compared to 2008, a 15% increase. Merchants’ taxable equivalent net interest margin increased to 3.80% from 3.58% over the same time period. Merchants’ average earning assets increased $105.93 million to $1.33 billion at an average rate of 5.02% for 2009 compared to $1.22 billion at an average rate of 5.63% for 2008. The decrease in the average rate earned on assets was more than offset by decreases in the cost of interest bearing liabilities, which decreased to 1.40% for 2009 from 2.33% for 2008.

The mix of the earning asset base changed during 2009 as Merchants was able to reposition its earning assets with a larger component in loans, Merchants’ highest yielding asset class. Average loans increased $119.94 million to $901.58 million at an average rate of 5.31% for 2009, from an average of $781.65 million at an average rate of 5.97% for 2008; while average investments decreased $39.98 million to $388.22 million at an average rate of 4.79% from an average of $428.20 million at an average rate of 5.05%; and average short-term investments increased $25.98 million to $36.53 million at an average rate of 0.29% from $10.55 million at an average rate of 3.33%.

Merchants deposit growth during 2009 was very strong, total average deposits increased to $1.00 billion, a $79.92 million, or 8.6% increase over average balances for 2008. The average cost of interest bearing deposits for 2009 was 1.08%, a decrease of 94 basis points from 2008. This decrease is largely a result of the low interest rate environment during all of 2009, and, to a lesser extent, a result of a slight shift in the make up of interest bearing deposits toward lower cost transaction accounts from time deposits. Merchants also had great success in growing its cash management sweep product during the year. This category is titled “Securities sold under agreements to repurchase, short-term” on the accompanying schedule. Average balances in this product increased $24.02 million to $108.30 million at an average rate of 0.57% for 2009 from $84.28 million at an average rate of 1.90% for 2008. Merchants also reduced its dependence on wholesale borrowing during the year and prepaid a total of $60.63 million in FHLB debt, at an average rate of 3.74%, over the course of 2009. Merchants incurred a prepayment penalty of $1.55 million in conjunction with the prepayment. Merchants estimates that it earned back approximately 40% of that prepayment penalty during 2009. Because $42.63 million of the prepayment occurred in the second half of the year, and most of that was in the last two months of the year, the annual average balance in this category only decreased by $10.08 million for 2009 compared to 2008.

Merchants closed its private placement of an aggregate of $20 million of trust preferred securities on December 15, 2004. The securities carried a fixed rate of interest at 5.95% through December 2009 at which time the rate became variable and adjusts quarterly at a fixed spread over three month LIBOR. The impact on net interest income for 2009 and 2008 from the interest expense on the trust preferred securities was $1.19 million per year.

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Merchants has entered into two interest rate swap arrangements for its trust preferred issuance. The swaps fix the interest rate on $10 million at 6.50% for three years and at 5.23% for seven years for the balance of $10 million. The swaps were effective beginning on December 15, 2009. Merchants’ blended cost of the trust preferred issuance beginning in December 2009 is 5.87% for a five-year average term. The trust preferred securities mature on December 31, 2034, and are redeemable without penalty at Merchants’ option, subject to prior approval by the Federal Reserve Bank (“FRB”), beginning December 15, 2009.

2008 compared with 2007

Merchants’ taxable equivalent net interest income increased $5.45 million to $43.74 million for 2008 compared to 2007, a 14% increase. Merchants’ net interest margin increased slightly to 3.58% for 2008 compared to 3.56% for 2007. This increase was a result of an overall higher earning asset base and a higher net interest rate spread for 2008 when compared to 2007. As shown in the following table, Merchants’ average earning assets for 2008 were $1.22 billion at an average yield of 5.63% compared to $1.08 billion at an average yield of 6.01% for 2007. Merchants took advantage of the steepening yield curve (the increased spread between short term and longer term rates) during 2008 to put some additional leverage on the balance sheet early in the year. Average investments for 2008 were $428.20 million at an average rate of 5.05% compared to $325.86 million at an average rate of 4.74% for 2007. Although rates moved down through most of 2008, credit spreads were wider and provided an opportunity to purchase high quality investments at attractive interest rates. Investments purchased during 2008 consisted exclusively of government agency mortgage backed securities (“MBS”) and government agency (“Agency”) collateralized mortgage obligations (“CMO”). Merchants also grew its loan portfolio during 2008; average loans for 2008 were $781.65 million, a $68.53 million, or 10%, increase over 2007 average loans. The average rate earned on the loan portfolio decreased to 5.97% from 6.64% for 2007. Although credit spreads on the loan side had also widened, the FRB decreased the prime lending rate by 4.0% during 2008, which had a direct impact on variable rate loan pricing.

Merchants’ average cost of funds decreased by 50 basis points to 2.33% for 2008 compared to 2.83% for 2007 while average interest bearing liabilities increased to $1.07 billion for 2008 compared to $931.59 million for 2007. Merchants’ average interest bearing deposits increased $53.12 million for 2008 compared to 2007. The average rate was 2.02%, 37 basis points lower than 2007. Merchants experienced a steady increase in its proportion of time deposits to total deposits over the last three years, but had not responded to competitive pressures and kept the average rate paid on these deposits at the low end of the market. Total average time deposits for 2008 were $376.58 million, a $50.64 million increase over average time deposits for 2007. Total average borrowed funds increased $85.48 million at an average rate of 3.27%, a 140 basis point decrease from 2007 levels.

25

The following table presents the condensed annual average balance sheets for 2009, 2008, and 2007. The total dollar amount of interest income from assets and the related yields are calculated on a taxable equivalent basis:

Merchants Bancshares, Inc.

Distribution of Assets, Liabilities and Shareholders' Equity; Interest Rates and Net Interest Margin

(a)

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

(b)

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

(c)

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

(d)

Excludes prepayment penalty of $1.55 million.

26

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

Merchants Bancshares, Inc.

Analysis of Changes in Fully Taxable Equivalent Net Interest Income

	2009 vs 2008
					Due to
				Increase			Volume/
(In thousands)	2009	2008		(Decrease)	Volume	Rate	Rate
Fully taxable equivalent interest income:
Loans	$  47,911	$  46,693		$  1,218	$  7,165	$ (5,156)	$     (791)
Investments	18,587	21,620		(3,033)	(2,019)	(1,118)	104
Federal funds sold, securities sold under    agreements to repurchase and interest    bearing deposits with banks	107	351		(244)	864	(320)	(788)
Total interest income	66,605	68,664		(2,059)	6,010	(6,594)	(1,475)
Less interest expense:
Savings, money market & NOW accounts	1,901	3,876		(1,975)	473	(2,182)	(266)
Time deposits	7,704	12,370		(4,666)	1,057	(5,272)	(451)
Federal Funds Purchased and Federal Home    Loan Bank short-term borrowings	20	82		(62)	32	(67)	(27)
Securities sold under agreements to repurchase,    short-term	621	1,604		(983)	457	(1,121)	(319)
Securities sold under agreements to repurchase,    long-term	1,970	2,193		(223)	(284)	71	(10)
Other long-term debt	2,818	3,614		(796)	(388)	(457)	49
Junior subordinated debentures issued to    unconsolidated subsidiary trust	1,190	1,190		--	--	--	--
Total interest expense	16,224	24,929		(8,705)	1,347	(9,028)	(1,024)
Net interest income	$  50,381	$  43,735		$  6,646	$  4,663	$  2,434	$     (451)

	2008 vs 2007
					Due to
				Increase			Volume/
(In thousands)	2008	2007		(Decrease)	Volume	Rate	Rate
Fully taxable equivalent interest income:
Loans	$  46,693	$  47,338		$    (645)	$  4,549	$ (4,739)	$     (455)
Investments	21,620	15,448		6,172	4,852	1,005	315
Federal funds sold, securities sold under    agreements to repurchase and interest    bearing deposits with banks	351	1,882		(1,531)	(1,336)	(672)	477
Total interest income	68,664	64,668		3,996	8,065	(4,406)	337
Less interest expense:
Savings, Money market & NOW accounts	3,876	4,779		(903)	28	(925)	(6)
Time deposits	12,370	13,181		(811)	2,048	(2,475)	(384)
Federal Funds Purchased and Federal Home    Loan Bank short-term borrowings	82	--		82	--	--	82
Securities sold under agreements to repurchase    short-term	1,604	3,503		(1,899)	(31)	(1,884)	16
Securities sold under agreements to repurchase,    long-term	2,193	1,326		867	2,110	(480)	(763)
Other long-term debt	3,614	2,407		1,207	2,042	(452)	(383)
Junior subordinated debentures issued to    unconsolidated subsidiary trust	1,190	1,190		--	--	--	--
Total interest expense	24,929	26,386		(1,457)	6,197	(6,216)	(1,438)
Net interest income	$  43,735	$  38,282		$  5,453	$  1,868	$  1,810	$  1,775

27

Provision for Credit Losses

The allowance for loan losses at December 31, 2009 was $10.98 million, 1.19% of total loans and 76% of non-performing loans, compared to the December 31, 2008 balance of $8.89 million, 1.05% of total loans and 76% of non-performing loans. Merchants recorded a provision expense of $4.10 million during 2009 compared to $1.53 million in 2008. The increase in the provision is the result of a number of factors:

•

Loans ended 2009 at $918.54 million, a $71.41 million, or 8.4% increase over year end 2008;

•

Non-performing loans increased to $14.48 million at December 31, 2009 from $11.64 million at December 31, 2008;

•

Accruing substandard loans increased to $16.19 million at December 31, 2009 from $13.74 million at December 31, 2008;

•

Net charge-offs for 2009 were $1.71 million compared to $564 thousand for 2008.

•

A prolonged period of high economic uncertainty that existed throughout 2009 and is projected to continue through much of 2010.

Merchants had $655 thousand in Other Real Estate Owned (“OREO”) at December 31, 2009 and $802 thousand at December 31, 2008. Nonperforming assets as a percentage of total assets were 1.05% at December 31, 2009 compared to 0.93% at December 31, 2008. All of these factors are taken into consideration during Management’s quarterly review of the Allowance which Management continues to deem adequate under current market conditions. For a more detailed discussion of Merchants’ Allowance and nonperforming assets, see “Credit Quality and Allowance for Credit Losses.”

NONINTEREST INCOME AND EXPENSES

Noninterest income

2009 compared to 2008

Merchants’ noninterest income increased by $1.66 million to $10.32 million for 2009 compared to $8.66 million for 2008. Excluding $1.22 million in gains on security transactions for 2009 and losses of $287 thousand in 2008, Merchants’ noninterest income increased $151 thousand to $9.10 million for 2009 compared to $8.95 million for 2008. Merchants’ Trust division income continued to decrease through the first three quarters of 2009 compared to 2008, but was higher for the fourth quarter of 2009 compared to the fourth quarter of 2008. Although the value of Trust division assets under management has rebounded during 2009, values have not returned to their early 2008 levels. Service charges on deposits were $234 thousand higher in 2009 than 2008, primarily a result of slightly higher net overdraft fee revenue. Regulatory changes scheduled to take effect during mid 2010 are likely to negatively impact overdraft fee income going forward. Merchants earned approximately $950 thousand in overdraft fee income related to debit card transactions; some portion of this may be at risk once these changes take effect. Other non-interest income was positively impacted by a gain of $180 thousand on the sale of Merchants’ Windsor, VT office.

Merchants’ equity in losses of real estate limited partnerships was $2.05 million for 2009 compared to $1.85 million for 2008. Merchants accounts for its investment in these partnerships using the equity method. Losses generated by the partnerships are recorded as a reduction in Merchants’ investments in the Consolidated Balance Sheets and as a reduction of noninterest income in the Consolidated Statements of Income. Tax credits generated by the partnerships are recorded as a reduction in the income tax provision. Merchants finds these investments attractive because they provide a high targeted internal rate of return, and provide an opportunity to invest in affordable housing in the communities in which Merchants does business.

2008 compared to 2007

Merchants’ noninterest income decreased by $686 thousand to $8.66 million for 2008 compared to 2007. Merchants recorded a $369 thousand other than temporary impairment charge related to one of its investment securities during the fourth quarter. Additionally, Merchants sold an investment in a limited partnership during the fourth quarter of 2007 and recognized a reduction in equity in losses of real estate limited partnerships of approximately $260 thousand. Excluding all security transactions and the gain just mentioned, noninterest income decreased by $236 thousand to $8.95 million year to date, primarily a result of decreases in Trust company income which has suffered in the current difficult market conditions, and has decreased by $126 thousand for 2008 compared to 2007.

28

Noninterest expense

2009 compared to 2008

Total noninterest expense increased 14.2% to $40.10 million for 2009 compared to $35.10 million for 2008. There are several reasons for this increase:

•

Salaries and wages increased $780 thousand, or 5.7%, to $14.51 million for 2009 compared to $13.73 million for 2008. Normal pay increases and a higher incentive payout for 2009 compared to 2008 combined with additional staff hired in the corporate banking, government banking and trust areas in late 2008 and 2009 contributed to the increase over the prior periods.

•

Employee benefits increased $475 thousand, or 12.3%, to $4.35 million for 2009 compared to $3.87 million for 2008. The largest year-over-year increase was Merchants’ pension plan expenses, which increased $391 thousand comparing 2009 to 2008. The increases in the remaining categories are directly related to increases in salaries.

•

Merchants’ total FDIC insurance expense increased $1.61 million to $1.96 million for 2009 compared to $356 thousand for 2008. Merchants recorded a $630 thousand expense related to the FDIC’s special assessment during the second quarter of 2009. Additionally, Merchants’ regular FDIC insurance assessment, excluding the special assessment, increased $978 thousand to $1.33 million for 2009, compared to 2008, due to both an increase in the FDIC’s assessment rates and an increase in deposits.

•

Other noninterest expense increased $319 thousand, or 5.4%, to $6.21 million for 2009 compared to $5.89 million for 2008. There were a number of reasons for this increase. Merchants has incurred expenses during 2009 related to its portfolio of problem loans and OREO. Those expenses totaled $292 thousand for 2009 compared to $25 thousand for 2008. Additionally, Merchants’ correspondent bank service charges have increased to $414 thousand for 2009, compared to $247 thousand for 2008. The large increases are a result of increased fees being passed on to Merchants by its primary correspondent bank, and a result of the very low interest rate environment. Merchants expenses related to internet banking and its cash back rewards program were $225 thousand higher for 2009 compared to 2008. At the same time Merchants reduced losses related to fraudulent activity by $225 thousand during 2009. Most categories of operating expenses increased for 2009 compared to 2008.

•

Merchants prepaid $60.63 million in FHLB debt during 2009, resulting in a $1.55 million prepayment penalty. No FHLB prepayment penalties were incurred in 2008 or 2007.

2008 compared to 2007

Total noninterest expense increased $2.81 million to $35.10 million for 2008 compared to $32.29 million for 2007. Salaries and employee benefits increased $1.97 million to $17.60 million for 2008 compared to $15.63 million for 2007. This increase was primarily a result of additional staff hired in the corporate banking, executive and trust areas during 2008, as well as increases in health insurance costs. Merchants’ pension plan expense for 2008 was flat at about $150 thousand compared to 2007 as a result of negative investment returns during 2008. Marketing expense for 2008 was $1.65 million, a $453 thousand increase over 2007. This increase was primarily a result of expenses incurred in conjunction with the rollout of Merchants’ new Cash Rewards Checking product. FDIC insurance expense totaled $355 thousand and $101 thousand in 2008 and 2007, respectively. Merchants also experienced large increases in its state assessment fees during 2008. Merchants incurred $159 thousand in expenses for the cash rebates associated with its new Cash Rewards Checking product mentioned previously. These expenses were offset, in part, by decreases in expenses associated with OREO properties which decreased by $370 thousand for 2008 compared to 2007. Additionally, most categories of operating expenses increased for 2008 compared to 2007.

Income Taxes

Merchants recognized $1.80 million, $1.70 million, and $1.65 million, respectively, during 2009, 2008, and 2007, in net low-income housing and historic rehabilitation tax credits as a reduction in the provision for income taxes; this resulted in an effective tax rate of 23.1%, 24.0%, and 23.1%, for 2009, 2008, and 2007, respectively. As of December 31, 2009, Merchants had a net deferred tax asset of approximately $3.19 million arising from temporary differences between Merchants’ book and tax reporting. This net deferred tax asset is included in Other assets in the Consolidated Balance Sheets.

29

BALANCE SHEET ANALYSIS

Merchants’ year-end total assets increased $94.04 million, or 7.0% to $1.44 billion at year end 2009 from $1.34 billion at year end 2008, while Merchants’ average earning assets increased by $105.93 million, or 8.7%, to $1.33 billion for the year ended December 31, 2009 from $1.22 billion at December 31, 2008.

Loans

Loans ended 2009 at $918.54 million, a $71.41 million, or 8.4%, increase over 2008 ending balances. Residential real estate loans grew $39.44 million, or 10%, commercial real estate balances grew $17.21 million, or 6.3%, and commercial loans declined $12.29 million, or 9.7% over 2008 ending balances. Commercial real estate balances are split almost evenly between owner occupied and investment real estate. The decrease in commercial loans is attributable to the general downturn in the market as well as a decrease in utilization rates of lines of credit to corporate borrowers. The largest increase was in municipal loans, which increased $41.99 million over 2008 ending balances, a result of the efforts of Merchants’ new Government Banking Unit formed during late 2008. Merchants continues to find opportunities with solid, long standing creditworthy businesses throughout Vermont, although loan demand during 2009 was lower than 2008. Loan growth was assisted by the favorable interest rate environment during the year, as well as focused marketing and calling efforts emphasizing Merchants’ unique position as the sole remaining statewide independent banking company. The Bank believes that the growth in home mortgages is a direct result of the fact that Merchants has not originated home mortgages for sale for over ten years and that Merchants’ customers prefer to have their mortgages held and serviced in Vermont.

The composition of Merchants’ loan portfolio is shown in the following table:

	As of December 31,
Type of Loan	2009	2008	2007	2006	2005
	(In thousands)
Commercial, Financial &  Agricultural	$  113,980	$  126,266	$    90,751	$    72,985	$    71,264
Municipal	44,753	2,766	1,989	527	648
Real Estate - Residential	435,273	395,834	356,472	323,885	293,158
Real Estate - Commercial	290,737	273,526	234,675	250,526	208,049
Real Estate - Construction	25,146	40,357	39,347	33,167	25,942
Installment	7,711	7,670	7,220	7,133	6,345
All Other Loans	938	708	1,054	1,060	520
	$  918,538	$  847,127	$  731,508	$  689,283	$  605,926

Totals above are shown net of deferred loans fees of $(140) thousand, $(74) thousand, $22 thousand, $95 thousand, and $275 thousand for 2009, 2008, 2007, 2006, and 2005, respectively.

Balances of real estate construction loans were $25.15 million at December 31, 2009, and reflect a 37.7% decline since December 31, 2008. The primary reason for the decrease during 2009 is the completion of construction on a significant multi-family housing project which converted to term financing, as planned, during 2009. Merchants remains focused on managing construction loans in a prudent manner, including ongoing oversight and review of construction loan draws and lien releases. Construction loans are comprised of the following:

•

Approximately $8.66 million of outstanding construction loans are dependent upon repayment from the sale of residential housing units, which represents steady reduction over the past two years from approximately $25.52 million in these types of loans outstanding at December 31, 2007. Of this total, $1.32 million in outstanding loans to two borrowers are considered impaired and are internally classified. Both of the impaired exposures are considered reasonably secured and are anticipated to be fully repaid through the cooperative sale of a nominal number of remaining units in 2010.

•

Approximately $3.18 million in outstanding construction loans are attributable to borrowers involved in the construction of multi-family residential housing, including several low income housing projects. Construction on these projects is on schedule and within budgets. These loans will be repaid from future rental income upon the conversion of the construction loans to term financing.

•

The balance of approximately $13.31 million consists of loans to commercial and investment real estate borrowers involved in a variety of commercial construction projects for offices, warehouses and retail space. These loans will generally be repaid from conversion to term financing upon completion of construction.

30

At December 31, 2009, Merchants serviced $3.66 million in residential mortgage loans for investors such as Federal government agencies, the Federal National Mortgage Association (“FNMA”) and the Federal Home Loan Mortgage Corporation (“FHLMC”), and other financial investors. This servicing portfolio continued to decrease during 2009. Merchants has not sold a residential mortgage on the secondary market in over ten years. Servicing revenue is not expected to be a significant revenue source in the future.

The following table presents the distribution of the varying contractual maturities of the loan portfolio at December 31, 2009:

Type of Loan	One Year Or Less	Over One Through 5 Years	Over Five Years	Total
	(In thousands)
Commercial Financial &  Agricultural	$    30,040	$    61,550	$    22,390	$  113,980
Municipal	41,360	2,328	1,065	44,753
Real Estate – Residential	10,081	73,052	352,140	435,273
Real Estate – Commercial	27,646	141,673	121,418	290,737
Real Estate – Construction	23,583	1,387	176	25,146
Installment	4,851	2,733	127	7,711
All Other	938	--	--	938
	$138,499	$282,723	$497,316	$918,538

The following table presents the loans maturing after one year which have predetermined interest rates and floating or adjustable interest rates as of December 31, 2009.

Type of Loan	Fixed	Adjustable
	(in thousands)
Commercial Financial &  Agricultural	$    40,665	$    43,275
Municipal	3,393	--
Real Estate – Residential	397,425	27,767
Real Estate – Commercial	180,051	83,040
Real Estate – Construction	971	592
Installment	2,814	46
	$625,319	$154,720

Investments

The investment portfolio is used to generate interest income, manage liquidity and mitigate interest rate sensitivity. Merchants’ year-end investment portfolio decreased $22.80 million from 2008 to 2009. Merchants worked to decrease its credit exposure in the non-Agency sector of the investment portfolio during 2009. Merchants sold its entire portfolio of commercial mortgage backed securities and several of its non-Agency CMOs during 2009. Additionally, Merchants sold three of its low coupon 30 year MBS during the last quarter of 2009. Merchants sold bonds with a total par value of $72.80 million during 2009 for a net gain of $1.22 million. All securities purchased during 2009 were Agency backed paper.

31

The composition of Merchants’ investment portfolio at carrying amounts is shown in the following table:

	As of December 31,
	2009	2008	2007
Available for Sale:	(In thousands)
U.S. Treasury Obligations	$         250	$         254	$         255
U.S. Agency Obligations	40,378	--	8,018
FHLB obligations	13,249	7,101	7,822
Agency Residential Real Estate MBS	190,995	281,523	164,564
Commercial Real Estate MBS	--	16,143	36,083
Agency CMO	153,041	95,940	86,607
Non-Agency CMO	6,862	24,709	35,530
Corporate Bonds	--	--	14,316
Asset Backed Securities	2,877	4,202	8,317
Total available for sale	407,652	429,872	361,512
Held to maturity:
Agency Residential Real Estate MBS	1,159	1,737	4,078
Total held to maturity	1,159	1,737	4,078
Total Securities	$  408,811	$  431,609	$  365,590

Agency MBS and Agency CMO consist of pools of residential mortgages which are guaranteed by the FNMA, FHLMC, or Government National Mortgage Association (“GNMA”) with various origination dates and maturities. Non-Agency CMO and asset backed securities (“ABS”) are tracked individually by Merchants’ investment manager with updates on the performance of the underlying collateral provided at least quarterly. Additionally, Merchants’ investment manager performs stress testing of individual bonds that experience greater levels of market volatility.

The non-Agency CMO portfolio consists of five bonds, one of which has an unrealized gain. One of the bonds, with a book value of $139 thousand has an unrealized loss of $10 thousand. Because of the insignificance of this loss, Merchants performed no additional analysis on this bond. Management has performed analyses on the remaining three bonds. Merchants’ 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 was determined to be remote.

The ABS portfolio consists of three bonds, one of which, with a book value of $357 thousand and a current market value of $306 thousand, carries an Agency guarantee. Merchants has performed no further analysis on this bond. The second bond is a private label asset backed security backed by home equity lines. Merchants receives monthly updates on this bond from its investment advisor. The bond, with a book value of $1.54 million and a fair value of $1.48 million, has insurance backing from Ambac Financial Group, Inc. (“Ambac”). However, Merchants places no reliance on the insurance wrap in its impairment analysis. The bond carries a AAA rating and credit support. Merchants has performed the same analysis on this bond as on its non-Agency CMOs discussed above and considers its impairment temporary.

The third bond in the ABS portfolio also has insurance backing from Ambac. Merchants places no reliance on the insurance wrap in its impairment analysis. The book value of the bond is $1.51 million, and its current market value is $1.10 million. The bond was written down by $369 thousand to its estimated fair value during the fourth quarter of 2008. Effective April 1, 2009 Merchants adopted Financial Accounting Standards Board (“FASB”) Accounting Standards Update (“ASU”) 320, “Recognition and Presentation of Other-Than-Temporary Impairment,” and reclassified to Accumulated Other Comprehensive Income $327 thousand (pre-tax), representing the portion of the OTTI charge resulting from factors other than credit. This is the only bond in Merchants’ bond portfolio with subprime exposure. Merchants has performed the same analyses on this bond as on its non-Agency CMOs discussed above, and considers the additional impairment of this bond to be temporary.

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

32

The contractual final maturity distribution of the debt securities classified as available for sale and held to maturity as of December 31, 2009, are as follows:

SECURITIES AVAILABLE FOR SALE (at fair value):

(In thousands)	Within One Year	After One But Within Five Years	After Five But Within Ten Years	After Ten Years	Total
U.S. Treasury Obligations	$       --	$       250	$          --	$            --	$         250
U.S. Agency Obligations	--	25,519	14,859	--	40,378
FHLB Obligations	--	13,249	--	--	13,249
Agency Residential Real Estate MBS	2,079	16,681	53,790	118,445	190,995
Agency CMO	--	3,288	16,281	133,472	153,041
Non-Agency CMO	--	--	1,458	5,404	6,862
ABS	--	--	--	2,877	2,877
	$  2,079	$  58,987	$  86,388	$  260,198	$  407,652
Weighted average investment yield	2.63%	2.79%	4.31%	4.27%

SECURITIES HELD TO MATURITY (at amortized cost):

(In thousands)	Within One Year	After One But Within Five Years	After Five But Within Ten Years	After Ten Years	Total
Agency Residential Real Estate MBS	$       23	$       390	$       121	$         625	$      1,159
Weighted average investment yield	6.85%	6.46%	6.63%	6.52%

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

As a member of the Federal Home Loan Bank (the “FHLB”) system, Merchants is required to invest in stock of the FHLB of Boston (the “FHLBB”) in an amount determined based on its borrowings from the FHLBB. At December 31, 2009 Merchants’ investment in FHLBB stock totaled $8.63 million. In early 2009, due to deterioration in its financial condition, the FHLBB placed a moratorium on redemption of stock in excess of required levels of ownership and suspended payment of quarterly dividends on its stock. No dividend income on FHLBB stock was recorded during 2009 and no dividend income on FHLBB stock is expected during 2010. FHLBB announced a $186.80 million net loss for 2009. The loss was primarily driven by losses due to the OTTI of its investment in private label MBS resulting in a credit loss of $444.10 million for 2009. FHLBB continues to be classified as “adequately capitalized” by its regulator. Based on current available information Merchants does not believe that its investment in FHLBB stock is impaired. Merchants will continue to monitor its investment in FHLBB stock.

Other Assets

Bank Premises and Equipment increased to $13.09 million at year-end 2009 from $11.56 million at year-end 2008. Merchants made the decision during 2008 to close three of its branches, two were closed in 2008, and one more closed in 2009. One of the properties was sold in early 2009 for an amount in excess of its current net book value. During 2009, Merchants completely refurbished one of its facilities in the Burlington area, expanded a full service facility in the southern part of the state, and also expanded one of its facilities in the southern part of the state to a full service branch.

Investments in Real Estate Limited Partnerships decreased $144 thousand. These partnerships provide affordable housing in the communities in which Merchants does business, and provide Merchants with an acceptable level of return on its investment.

33

On June 27, 2008, Merchants entered into two agreements effecting the sale and lease-back of its principal office in South Burlington, VT. The sale price of the building was $5.70 million and Merchants will lease back the property for an initial term of ten years and two optional terms of five years each. The base annual rent is $483 thousand for each of the first ten years, $557 thousand for each of years 11-15, and $612 thousand for each of years 16-20. The sale of the building generated a deferred gain of approximately $4.20 million which will be recognized over the term of the lease. Depreciation expense related to the building prior to the sale totaled $167 thousand annually.

Deposits

Merchants’ year-end deposit balances increased $112.52 million, or 12.1%, to $1.04 billion at December 31, 2009 from $930.80 million at December 31, 2008. The composition of Merchants’ deposit balances is shown in the following table:

	As of December 31,
Type of Deposit	2009	2008	2007
	(In thousands)
Demand	$     119,742	$  117,728	$  123,344
Free Checking for Life®	234,028	182,580	178,829
Other Savings and NOW	47,837	38,424	39,149
Money Market Accounts	247,169	206,944	193,343
Time Deposits	394,543	385,121	332,772
	$  1,043,319	$  930,797	$  867,437

All deposit categories grew over 2008 year end balances. Free Checking for Life^® year end 2009 balances grew $51.45 million, or 28.2% over year end 2008 balances. Growth in municipal deposits was the greatest contributor to the increase in money market accounts. Time deposits represented 38% of Merchants’ total deposits at December 31, 2009 compared to 41% of total deposits at December 31, 2008.

Time Deposits of $100 thousand and greater at December 31, 2009 and 2008 had the following schedule of maturities:

	As of December 31,
(In thousands)	2009	2008
Three Months or Less	$    49,230	$    29,921
Three to Six Months	31,612	31,293
Six to Twelve Months	39,522	49,054
One to Five Years	13,783	3,716
	$  134,147	$  113,984

Other Liabilities

Merchants has a cash management sweep product which is priced at a lower cost of funds than other short-term borrowing alternatives. Balances in this product totaled $178.31 million at December 31, 2009, compared to $92.41 million at December 31, 2008. The balances are included with “Securities sold under agreements to repurchase and other short-term debt” on the accompanying consolidated balance sheet. The increase from 2008 to 2009 is primarily a result of strong growth in Merchants’ municipal portfolio. Merchants’ other long-term debt position decreased to $31.22 million at December 31, 2009 from $118.64 million at December 31, 2008. As mentioned previously, Merchants prepaid $60.63 million in FHLB debt during 2009. Merchants also has $54 million in structured repurchase agreements (“repo”) on the balance sheet. The cost of the structured repo funding will be reduced by the cash flows of embedded interest rate caps that will provide additional protection if rates start to move up. The caps come into the money when three month LIBOR reaches rates ranging from 3.22% to 5.62%.

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

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These hybrid securities qualify as regulatory capital for Merchants, up to certain regulatory limits. At the same time they are considered debt for tax purposes, and as such, interest payments are fully deductible. The trust preferred securities total $20.62 million, and carried a fixed rate of interest through December 2009 at which time the rate became variable and adjusts quarterly at a fixed spread over three month LIBOR. Merchants has entered into two interest rate swap arrangements for its trust preferred issuance. The swaps fix the interest rate on $10 million at 6.50% for three years and at 5.23% for seven years for the balance of $10 million. The swaps were effective beginning on December 15, 2009. The trust preferred securities mature on December 31, 2034, and are redeemable at Merchants’ option, subject to prior approval by the FRB, beginning in December 2009.

CREDIT QUALITY AND ALLOWANCE FOR CREDIT LOSSES

The United States economy has been in a state of unprecedented turmoil over the last 18 months, with high degrees of economic uncertainty, high unemployment rates and very high foreclosure rates in certain parts of the country. Although Vermont, Merchants’ primary market, has not been immune to this economic turmoil, the state has one of the lowest foreclosure rates in the country, home price depreciation has been muted, and the unemployment rate, at 6.9%, is better than the national average. Merchants $388 million residential first lien mortgage portfolio consists entirely of traditional mortgages – more than 97% of them are fixed rate loans, the balance are standard adjustable rate mortgages. Additionally, 97% of Merchants’ residential loans have loan to value ratios (“LTV”) of less than 80% based upon amortized loan balance compared to appraised value at origination. Merchants total 30-89 day delinquencies at December 31, 2009 were 0.09% of total loans, residential delinquencies were 0.06% of total loans and were 0.12% of residential loans. Merchants foreclosed on two residential properties during 2009, one of those properties is currently under deposit and the other is being marketed for sale.

Credit quality

Stringent credit quality is a major strategic focus of Merchants. Although Merchants is actively managing current nonperforming and classified loans, there is no assurance that Merchants will not have increased levels of problem assets in the future. The make up of the nonperforming pool is dynamic with accounts moving in and out of this category during the course of a quarter. The following table summarizes Merchants’ nonperforming loans (“NPL”) and nonperforming assets (“NPA”) as of December 31, 2005, through December 31, 2009:

(In thousands)	2009	2008	2007	2006	2005
Nonaccrual loans	$  14,296	$  11,476	$  9,018	$  2,606	$  2,284
Loans past due 90 days or  more and still accruing	88	57	57	--	--
Troubled debt restructurings	97	110	156	92	80
Total nonperforming loans	14,481	11,643	9,231	2,698	2,364
OREO	655	802	475	258	--
Total nonperforming assets	$  15,136	$  12,445	$  9,706	$  2,956	$  2,364

Non-performing loans increased to $14.48 million at December 31, 2009, an increase of $2.84 million since the prior year-end primarily attributable to a similar increase in non-accrual loans. Merchants continues to manage its non-accrual loan exposures in a prudent and proactive fashion and progress has been made in working through existing balances. Total non-accrual loan balances at December 31, 2008, of $11.48 million have been reduced significantly to approximately $4.72 million at December 31, 2009 due to $5.67 million in collections occurring during 2009 plus $1.09 million in write-downs. Offsetting this progress were net new non-accrual loans added during the year of approximately $11.58 million, against which the bank has collected approximately $2.01 million in repayments through year-end. These additions to non-accrual were reflective of Management’s concerns regarding fundamental credit issues with the repayment abilities of the borrowers and not, in most cases, as a result of payment delinquencies. Of the total non-accruing loans at year-end 2009, approximately 77% were attributable to six borrowers; a substantial portion of this amount relates to loans to a manufacturer that were added to non-accrual during the fourth quarter of 2009. Management’s analysis indicates that, through a combination of properly valued collateral and a substantial allocated reserve, any additional loss exposure is currently deemed minimal.

OREO at December 31, 2009 consisted of two bank-owned properties which are carried at fair value less costs to sell. The larger of the two properties was sold in early February 2010 and Merchants booked a $318 thousand expense recovery in connection with the sale. The balance in OREO subsequent to this sale was $41 thousand. The remaining property is being marketed, and is anticipated to sell in full satisfaction of its carrying balance in 2010.

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Merchants’ 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 when the loan is determined to be uncollectible, and is charged off against the allowance for loan losses. In those cases where a nonaccruing loan is secured by real estate, Merchants can, and may, initiate foreclosure proceedings. The result of such action will either be to cause repayment of the loan with the proceeds of a foreclosure sale or to give Merchants possession of the collateral in order to manage a future resale of the real estate. Foreclosed property is recorded at the lower of its cost or estimated fair value, less any estimated costs to sell. Any cost in excess of the estimated fair value on the transfer date is charged to the allowance for loan losses, while further declines in market values are recorded as OREO expense in the consolidated statement of income. Impaired loans, which primarily consist of nonaccruing construction, commercial and commercial real estate loans totaled $14.48 million and $10.98 million at December 31, 2009 and 2008, respectively, and are included as nonaccrual loans in the table above. At December 31, 2009 $8.39 million of the impaired loans had a specific reserve allocation of $1.82 million.

Substandard loans include $14.48 million of the impaired loans discussed above and another $16.19 million of loans that continue to accrue interest. 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 Merchants’ Loan Loss Reserve.

Substandard accruing loans reflect a $2.45 million increase in balances since December 31, 2008. Accruing substandard loans related to owner occupied commercial real estate total $8.87 million at December 31, 2009; investor real estate loans total $5.85 million; commercial construction loans total $629 thousand and $845 thousand in loans are made to corporate borrowers in a variety of different industries. Six borrowers account for 65% of the total accruing substandard loans (two of which were 2009 downgrades totaling $3.42 million), including $2.94 million in loans to a manufacturer/retailer; $3.53 million in loans to manufacturers and $1.82 million in loans to a retailer. Approximately $4.65 million of total substandard loans carry some form of government guarantee.

To date, with very few exceptions, all payments due from accruing substandard borrowers have been made as agreed and Management’s on-going evaluation of these borrowers in terms of financial condition and collateral indicates a reasonable certainty that these exposures are adequately secured. Merchants’ Management will continue to closely monitor asset quality.

Merchants performs detailed and extensive reviews on larger credits and problematic credits identified on the watched asset list, nonperforming asset listings and internal credit rating reports. In addition to frequent financial analysis and review of well-rated and adversely graded loans, Management incorporates 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.

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 Management's estimate of the amount required to reflect the known and inherent risks in the loan portfolio, based on circumstances and conditions known at each reporting date. Merchants reviews the adequacy of the 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, Merchants determines 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 allowance for loan losses if Management needs more time to evaluate all of the facts and circumstances relevant to that particular loan.

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The general allowance for loan losses is a percentage-based reflection of historical loss experience and assigns a required allocation by loan classification based on a fixed percentage of all outstanding loan balances. The general allowance for loan losses employs a risk-rating model that grades loans based on their general characteristics of credit quality and relative risk. 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 non-accrual loans.

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

(In thousands)	2009	2008	2007	2006	2005
Commercial Financial &  Agricultural	$    3,106	$  2,840	$  1,843	$  1,236	$  1,339
Municipal	134	--	--	--	--
Real Estate - Residential	2,222	1,033	775	687	586
Real Estate -Commercial	4,943	4,254	4,204	4,567	2,066
Real Estate - Construction	349	542	1,070	332	431
Installment	39	4	4	4	13
All other Loans	183	221	106	85	113
Unallocated Allowance	--	--	--	--	2,535
Allowance for Loan Losses	$  10,976	$  8,894	$  8,002	$  6,911	$  7,083

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

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

(In thousands)	2009	2008	2007	2006	2005
Average Loans Outstanding	$901,582	$781,645	$713,119	$648,713	$589,408
Allowance Beginning of Year	9,311	8,350	7,281	7,083	7,512
Charge-offs:
Commercial, Financial & Agricultural    and all Other Loans	(1,613)	(16)	(170)	(46)	(336)
Real Estate – Construction	--	(637)	--	--	(218)
Real Estate – Residential	(255)	(28)	(242)	(13)	(121)
Installment	(8)	--	(20)	(4)	(18)
Total Charge-offs	(1,876)	(681)	(432)	(63)	(693)
Recoveries:
Commercial, Financial & Agricultural    and all Other Loans	164	60	271	236	144
Real Estate – Residential	2	57	79	14	115
Installment	1	--	1	11	5
Total Recoveries	167	117	351	261	264
Net (Charge-offs) Recoveries	(1,709)	(564)	(81)	198	(429)
Provision for Credit Losses	4,100	1,525	1,150	--	--
Allowance End of Year	$  11,702	$    9,311	$    8,350	$    7,281	$    7,083

Components:

Allowance for loan losses	$  10,976	$    8,894	$    8,002	$    6,911	$    7,083
Reserve for undisbursed lines of credit (1)	726	417	348	370	--
Allowance for Credit Losses	$  11,702	$    9,311	$    8,350	$    7,281	$    7,083

(1)

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

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Merchants recorded a provision expense of $4.10 million during 2009 compared to $1.53 million during 2008. The increase in the provision is primarily a result of overall loan growth combined with an increase in non-performing and accruing classified loans and net charge-offs during the year, combined with continued economic uncertainty. Merchants did not consider additions to the allowance necessary in 2005 and 2006 because Merchants’ loss experience had been relatively low, non-performing assets had remained at consistently low levels, and a large percentage of the growth in the loan portfolio had been in less risky residential categories.

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

	2009	2008	2007	2006	2005
NPL to total loans	1.58%	1.37%	1.26%	0.39%	0.39%
NPA to total assets	1.05%	0.93%	0.83%	0.26%	0.22%
Allowance for loan losses to total loans	1.19%	1.05%	1.09%	1.00%	1.17%
Allowance for loan losses to NPL	76%	76%	87%	256%	300%

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

Loan Portfolio Monitoring

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

The Loan Committee and the credit department regularly monitor Merchants’ loan portfolio. The entire loan portfolio, as well as individual loans, is reviewed for loan performance, compliance with internal policy requirements and banking regulations, creditworthiness, and strength of documentation. Merchants monitors loan concentrations by individual borrowers, industries and loan types. As part of the annual credit policy review process, targets are set by loan type for the total portfolio. 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, plus Merchants maintains an on-going active monitoring process of loan performance during the year. In addition, Merchants has hired external loan review firms to assist in monitoring both the commercial and residential loan portfolios. During 2009 the commercial loan review firm reviewed approximately 60% (in dollar volume) of Merchants’ commercial loan portfolio. These comprehensive reviews assessed 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 or the 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.

RELATED PARTY TRANSACTIONS

Merchants engages in banking transactions with certain of its directors and officers, and certain of their affiliates. During 2009, Merchants obtained legal services from a firm associated with one of its directors totaling $8 thousand; and project management services from a firm associated with one of its directors totaling $51 thousand. Merchants obtained insurance during 2009 through an insurance agency of which a director of Merchants Bank is president. In 2009, payments to the insurance agency totaled $13 thousand. Merchants obtains these services on terms that are comparable to those that it would obtain from unaffiliated third parties.

At December 31, 2009, Merchants had total loans outstanding to directors, executive officers, and associates of such persons totaling $3.44 million. It is the policy of Merchants to make these loans on substantially the same terms, including interest rates and collateral, as those prevailing for comparable lending transactions with other persons. As of December 31, 2009, all loans to directors, officers, and certain of their affiliates, were performing in accordance with their contractual terms.

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EFFECTS OF INFLATION

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

RECENT ACCOUNTING PRONOUNCEMENTS

Measuring Liabilities at Fair Value: In August 2009, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2009-05, “Fair Value Measurements and Disclosures (Topic 820) – Measuring Liabilities at Fair Value.” This ASU provides amendments for fair value measurements of liabilities. It provides clarification that in circumstances in which a quoted price in an active market for the identical liability is not available, a reporting entity is required to measure fair value using one or more techniques. ASU No. 2009-05 also clarifies that when estimating a fair value of a liability, a reporting entity is not required to include a separate input or adjustment to other inputs relating to the existence of a restriction that prevents the transfer of the liability. ASU No. 2009-05 is effective for the first reporting period (including interim periods) beginning after issuance or fourth quarter 2009. Effective for financial statements issued on September 30, 2009, the standard did not change the way Merchants determines the fair value of its liabilities.

Amendments to FASB Interpretation No. 46(R): In June 2009, the FASB issued Statement No. 167, “Amendments to FASB Interpretation No. 46(R)” (SFAS No. 167). SFAS No. 167 addresses (1) the effects on certain provisions of FASB Interpretation No. 46 (revised December 2003), “Consolidation of Variable Interest Entities,” as a result of the elimination of the qualifying special-purpose entity concept in FASB Statement No. 166, “Accounting for Transfers of Financial Assets,” and (2) constituent concerns about the application of certain key provisions of Interpretation 46(R), including those in which the accounting and disclosures under the Interpretation do not always provide timely and useful information about an enterprise’s involvement in a variable interest entity. This Statement is effective as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period, and for interim and annual reporting periods thereafter. Earlier application is prohibited. Although Merchants is assessing the potential impact of this statement, Merchants does not expect it to have a material impact on its financial condition or results of operations.

Subsequent Events: In February 2010, the FASB issued ASU 2010-09 on Subsequent Events. The new ASU amends certain recognition and disclosure requirements for subsequent events in Accounting Standards Codification (“ASC”) Topic 855 (originally issued in FASB Statement No. 165, "Subsequent Events"). Among other things, the ASU eliminates the requirement for SEC filers, as defined in the ASU, to disclose the date through which subsequent events have been evaluated. That change is effective immediately. SEC filers continue to be required to evaluate subsequent events through the date the financial statements are issued. Although the ASU eliminates the requirement for SEC filers to disclose the date through which subsequent events have been evaluated, it does not prohibit that disclosure. Accordingly, SEC filers are not prohibited from disclosing the date through which subsequent events have been evaluated.

LIQUIDITY AND CAPITAL RESOURCE MANAGEMENT

General

Merchants’ liquidity is monitored by the Asset and Liability Committee (“ALCO”) of Merchants Bank’s Board of Directors which delegates responsibility of day-to-day liquidity monitoring and policy compliance to the Management ALCO. Merchants has an overnight line of credit with the FHLBB of $5 million and an estimated additional borrowing capacity with the FHLBB of $86 million. In early 2009, due to deterioration in its financial condition, the FHLBB placed a moratorium on redemption of stock in excess of required levels of ownership and suspended payment of quarterly dividends on its stock. FHLBB announced a $186.80 million net loss for 2009. The loss was primarily driven by losses due to the OTTI of its investment in private label MBS resulting in a credit loss of $444.10 million for 2009. FHLBB continues to be classified as “adequately capitalized” by its primary regulator. Although Merchants does not expect that this funding source will become unavailable, Merchants has ensured that it has other sources of readily available funds.

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Merchants has established a borrowing facility with the FRB which will enable Merchants to borrow at the discount window. Additionally, Merchants has $44 million in available federal funds lines of credit at December 31, 2009 and the ability to borrow through the use of repurchase agreements, collateralized by Merchants’ investments, with certain approved counterparties. Merchants’ investment portfolio, which is managed by the ALCO, has a book value of $400.24 million at December 31, 2009, of which $269.90 million was pledged. The portfolio is a reliable source of cash flow for Merchants. Merchants is closely monitoring its short term cash position in the current uncertain economic environment. Excess funds are generally left on deposit at the FRB.

Contractual Obligations

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

(In thousands)	Less than One year	One Year To Three Years	Three Years To Five Years	Over Five Years	Total
Debt maturities	$         76	$     156	$  8,663	$22,320	$  31,215
Securities sold under agreement to  repurchase, long-term	--	--	54,000	--	54,000
Junior subordinated debentures	--	--	--	20,619	20,619
Operating lease payments	1,005	1,855	1,293	3,678	7,831
Time deposits	350,640	19,208	24,695	--	394,543
	$351,721	$21,219	$ 88,651	$46,617	$508,208

Commitments and Off-Balance Sheet Risk

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

Exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and financial guarantees written is represented by the contractual amount of those instruments. Merchants uses the same credit policies in making commitments as it does for on-balance sheet instruments. The contractual amounts of these financial instruments at December 31, 2009 are as follows:

(In thousands)	Contractual Amount
Financial Instruments Whose Contract Amounts  Represent Credit Risk:
Commitments to Originate Loans	$  10,642
Unused Lines of Credit	160,868
Standby Letters of Credit	3,796
Loans Sold with Recourse	84
Equity Commitments to Affordable Housing  Limited Partnerships	3,678

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

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Merchants does not issue any guarantees that would require liability-recognition or disclosure, other than its standby letters of credit. Merchants has issued conditional commitments in the form of standby letters of credit to guarantee payment on behalf of a customer and guarantee the performance of a customer to a third party. Standby letters of credit generally arise in connection with lending relationships. The credit risk involved in issuing these instruments is essentially the same as that involved in extending loans to customers. Contingent obligations under standby letters of credit totaled approximately $3.80 million and $3.90 million at December 31, 2009 and 2008, respectively, and represent the maximum potential future payments Merchants could be required to make. Typically, these instruments have terms of 12 months or less and expire unused; therefore, the total amounts do not necessarily represent future cash requirements. Each customer is evaluated individually for creditworthiness under the same underwriting standards used for commitments to extend credit and on-balance sheet instruments. Merchants’ policies governing loan collateral apply to standby letters of credit at the time of credit extension. Loan-to-value ratios are generally consistent with loan-to-value requirements for other commercial loans secured by similar types of collateral. The fair value of Merchants’ standby letters of credit at December 31, 2009 and 2008 was insignificant.

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

Capital Resources

In general, capital growth is essential to support deposit and asset growth and to ensure the strength and safety of Merchants. Net income increased Merchants’ capital by $12.48 million in 2009, $11.92 million in 2008 and $10.86 million in 2007. Payment of dividends decreased Merchants’ capital by $6.83 million, $6.80 million and $6.90 million during 2009, 2008 and 2007, respectively. In December 2004, Merchants, through a newly formed subsidiary business trust, privately placed $20 million in capital securities as part of pooled trust preferred program. These capital securities have certain features that make them an attractive funding vehicle. The securities qualify as regulatory capital under regulatory adequacy guidelines, and are included in capital in the table below.

Merchants did not repurchase any stock under its stock buyback program during 2009. Stock repurchases decreased Merchants’ capital by $2.02 million during 2008. In addition, changes in the market value of Merchants’ available for sale investment portfolio, net of tax, increased capital by $3.58 million in 2009 and $2.27 million in 2008. Merchants’ pre-tax unrecognized net actuarial loss in its pension plan was $3.78 million at December 31, 2009 which resulted in a cumulative after-tax charge to equity of $2.46 million. Merchants’ unrealized loss on the interest rate swap, net of taxes, at December 31, 2009, reduced capital by $425 thousand.

In January 2007 Merchants’ Board of Directors approved a stock repurchase program pursuant to which Merchants may repurchase 200,000 shares of its stock from time to time through January 2008. The program was extended by the Board at its meetings in January 2008, 2009 and 2010, and the program has now been extended to January 2011. Through December 31, 2009, Merchants purchased 143,475 shares of its common stock on the open market under the program at an average per share price of $22.94.

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ITEM 7A—QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

RISK MANAGEMENT

General

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

Market Risk

Market risk is the risk of loss in a financial instrument arising from adverse changes in market rates or prices such as interest rates, foreign currency exchange rates, commodity prices, and equity prices. Merchants’ primary market risk exposure is interest rate risk. An important component of Merchants’ asset and liability management process is the ongoing monitoring and management of this risk, which is governed by established policies that are reviewed and approved annually by Merchants Bank’s Board of Directors. The Investment policy details the types of securities that may be purchased, and establishes portfolio limits and maturity limits for the various sectors. The Investment policy also establishes specific investment quality limits. Merchants Bank’s Board of Directors has established a board level Asset and Liability Committee, which delegates responsibility for carrying out the asset/liability management policies to the management level ALCO. The ALCO, chaired by the Chief Financial Officer and composed of members of senior management, develops guidelines and strategies impacting Merchants’ asset and liability management related activities based upon estimated market risk sensitivity, policy limits and overall market interest rate levels and trends. The ALCO manages the investment portfolio. As the portfolio has grown, the ALCO has used portfolio diversification as a way to mitigate the risk of being too heavily invested in any single asset class. Merchants continued to work to maximize net interest income while mitigating risk during 2009 through further repositioning of the investment portfolio, selective sales of specific securities, as well as carefully monitoring the overall duration and average life of the portfolio, and monitoring individual securities, among other strategies. Merchants has an outside investment advisory firm which helps it identify opportunities for increased yield, without significantly increasing risk, in the investment portfolio. 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

Merchant’s liquidity is measured by its ability to raise cash when needed at a reasonable cost. Merchants 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, Merchants 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 Resource Management,” Merchants has several sources of readily available funds, including the ability to borrow using its investment portfolio as collateral. Merchants also monitors its liquidity on a quarterly basis in compliance with its Liquidity Contingency Plan.

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 Federal Reserve System discount window to secure adequate funding. Because of Merchants’ favorable credit quality and strong balance sheet, Merchants has not experienced any liquidity constraints through the end of 2009. During the past several quarters, Merchants’ liquidity position has been strong, as depositors and investors in the wholesale funding markets seek strong financial institutions.

Interest Rate Risk

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

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The ALCO is responsible for evaluating and managing the interest rate risk which arises naturally from imbalances in repricing, maturity and cash flow characteristics of Merchants’ assets and liabilities. Techniques used by the ALCO take into consideration the cash flow and repricing attributes of balance sheet and off-balance sheet items and their relation to possible changes in interest rates. The ALCO manages interest rate exposure primarily by using on-balance sheet strategies, generally accomplished through the management of the duration, rate sensitivity and average lives of Merchants’ various investments, and by extending or shortening maturities of borrowed funds, as well as carefully managing and monitoring the pricing of loans and deposits. The ALCO also considers the use of off-balance sheet strategies, such as interest rate caps and floors and interest rate swaps, to help minimize the Company’s exposure to changes in interest rates. By using derivative financial instruments to hedge exposures to changes in interest rates Merchants exposes itself 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 Merchants, which creates credit risk for Merchants. Merchants minimizes 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 Merchants Bank’s Board of Directors receives accurate information regarding Merchants’ interest rate risk position at least quarterly. The investment advisory firm and ALCO consultant meet collectively with the board and Management level Asset and Liability Committees on a quarterly basis. During these meetings the ALCO consultant reviews Merchants’ current position and discusses future strategies, as well as reviewing the result of rate shocks of its balance sheet and a variety of other analyses. The investment advisor reports on the overall performance of the portfolio and performs modeling of the cash flow, effective duration, and yield characteristics of the portfolio under various interest rate scenarios; and also reviews and provides detail on individual holdings in the portfolio.

As of December 31, 2009, Merchants’ one-year static gap position was a $209.31 million liability sensitive position, an increase from the $148.39 million liability sensitive position at December 31, 2008. This change is a result of deposit growth during the year being concentrated in transaction accounts and short term CDs as customers have chosen to keep their money short; strong growth in retail short term repurchase agreements; the prepayment of FHLB debt discussed previously; and changes in prepayment speed assumptions for mortgage related products in the current interest rate environment. Merchants’ investment consultant modeled 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. Merchants has established a target range for the change in net interest income of zero to 7.5%. The net interest income simulation as of December 31, 2009 showed that the change in net interest income for the next 12 months from Merchants’ expected or “most likely” forecast was as follows:

Rate Change	Percent Change in Net Interest Income
Up 200 basis points	(0.49)%
Down 100 basis points	0.80%

The analysis assumes a static balance sheet. All rate changes are ramped over a 12 month time horizon based upon a parallel yield curve shift. In the down 100 basis points scenario, Federal funds and Treasury yields are floored at 0.01% while Prime is floored at 3.00%. All other market rates (e.g. LIBOR, FHLB) are floored at 0.25% to reflect credit spreads. All risk levels were within policy guidelines. Under the current rate scenario, net interest income is projected to trend sideways over the first year of the simulation as the benefit of deposit cost reduction is offset by lower reinvestment yields for asset cash flows. Thereafter funding costs will begin to stabilize. Declining asset yields will lead to ongoing downward pressure on margin levels. If rates fall, net interest income is projected to trend higher during the first year due to assumed relief on deposit rates. Thereafter, declining margins are led by accelerated prepayments on mortgage-related assets driving yields lower. In a rising rate environment net interest income is projected to trend sideways for the first 18 months as asset yields move up moderately due to the reduced cash flow on mortgage related assets, while deposit rates are assumed to move up marginally compared to market rates. Thereafter margins widen as rising funding costs subside, and assets continue to reprice upward. If the yield curve should flatten as rates rise, net interest income would trend below the base case as longer term assets are less rate sensitive. The degree to which this exposure materializes will depend, in part, on Merchants’ ability to manage deposit and loan rates as interest rates rise or fall.

The 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.

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The most significant ongoing factor affecting market risk exposure of net interest income during the year ended December 31, 2009 was the current global economic crisis and the U.S. Government’s response. Interest rates plummeted during 2008 and remained low during 2009 as the global economy slowed at unprecedented levels, unemployment levels soared, delinquencies on all types of loans increased along with decreased consumer confidence and dramatic declines in housing prices. 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. During 2009, the two year Treasury note increased by 38 basis points and the ten year Treasury note increased by 160 basis points. The spread between the two year and the ten year Treasury notes ended the year at 271 basis points, compared to 149 basis points at December 31, 2008.

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

Merchants’ interest rate sensitivity gap ("gap") is pictured below as of December 31, 2009. Interest rate gap analysis provides a static view of the maturity and repricing characteristics of Merchants’ on and off-balance sheet positions. Gap is defined as the difference between assets and liabilities repricing or maturing within specified periods. An asset-sensitive position (“positive gap”) indicates that there are more rate-sensitive assets than rate-sensitive liabilities repricing or maturing within a specified time period, which would imply a favorable impact on net interest income during periods of rising interest rates. Conversely, a liability-sensitive position (“negative gap”) generally implies a favorable impact on net interest income during periods of falling interest rates. There are certain limitations inherent in a static gap analysis. These limitations include the fact that it is a static measurement and that it does not reflect the degree to which interest earning assets and interest bearing deposits may respond non-proportionally to changes in market interest rates. Although the ALCO reviews all assumptions used in the model in detail, assets and liabilities do not always have clear repricing dates, and may reprice earlier or later than assumed in the model.

	Repricing Date
(In thousands)	One Day To Six Months	Over Six Months To One Year	One Year To Five Years	Over Five Years	Total
Interest-earning assets
Loans	$  290,910	$    87,371	$  400,552	$  139,705	$  918,538
U.S. Treasury & Agency Securities	8,514	32,498	7,249	--	48,261
Mortgage Backed Securities and    Collateralized Mortgage    Obligations	53,307	56,685	188,382	58,568	356,942
Other securities	10,316	146	691	1,085	12,238
Interest bearing cash equivalents	43,894	5,000	--	20	48,914
Total interest-earning assets	$  406,941	$  181,700	$  596,874	$  199,378	$1,384,893
Interest-bearing liabilities:
Interest-bearing deposits	465,377	132,127	44,142	281,931	923,577
Short-term borrowings	179,718	--	--	--	179,718
Long-term debt	20,675	56	60,469	24,634	105,834
Total interest-bearing liabilities	$  665,770	$  132,183	$  104,611	$  306,565	$1,209,129
Cumulative Gap	$ (258,829)	$ (209,312)	$  282,951	$  175,674	--
Cumulative Gap as a % of average  earning assets	(19.51)%	(15.78)%	21.33%	13.25%	--

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

Credit Risk

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

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ITEM 8—FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Merchants Bancshares, Inc.

Consolidated Balance Sheets

			December 31,	December 31,
(In thousands except share and per share data)			2009	2008
ASSETS
Cash and cash equivalents			$       64,276	$       36,145
Federal funds sold and other short-term investments			10,270	111
Total cash and cash equivalents			74,546	36,256
Investments:
Securities available for sale, at fair value			407,652	429,872
Securities held to maturity (fair value of $1,248 and $1,810)			1,159	1,737
Total investments			408,811	431,609
Loans			918,538	847,127
Less: Allowance for loan losses			10,976	8,894
Net loans			907,562	838,233
Federal Home Loan Bank stock			8,630	8,523
Bank premises and equipment, net			13,090	11,561
Investment in real estate limited partnerships			5,220	5,364
Other assets			17,389	9,664
Total assets			$  1,435,248	$  1,341,210
LIABILITIES
Deposits:
Demand deposits			$     119,742	$     117,728
Savings, NOW and money market accounts			529,034	427,948
Time deposits $100 thousand and greater			134,147	113,984
Other time deposits			260,396	271,137
Total deposits			1,043,319	930,797
Securities sold under agreements to repurchase and other short-term debt			179,718	124,408
Securities sold under agreements to repurchase, long-term			54,000	54,000
Other long-term debt			31,215	118,643
Junior subordinated debentures issued to unconsolidated subsidiary trust			20,619	20,619
Other liabilities			15,365	13,046
Total liabilities			1,344,236	1,261,513
Commitments and contingencies (Note 14)
SHAREHOLDERS' EQUITY
Preferred stock Class A non-voting
Shares authorized - 200,000, none outstanding			--	--
Preferred stock Class B voting
Shares authorized - 1,500,000, none outstanding			--	--
Common stock, $.01 par value			67	67
Shares authorized		10,000,000
Issued	As of December 31, 2009 and December 31, 2008	6,651,760
Outstanding	As of December 31, 2009	5,815,370
	As of December 31, 2008	5,737,428
Capital in excess of par value			36,278	36,862
Retained earnings			63,552	57,689
Treasury stock, at cost			(17,798)	(19,853)
	As of December 31, 2009	836,390
	As of December 31, 2008	914,332
Deferred compensation arrangements			6,246	6,117
Accumulated other comprehensive income (loss)			2,667	(1,185)
Total shareholders' equity			91,012	79,697
Total liabilities and shareholders' equity			$  1,435,248	$  1,341,210

See accompanying notes to consolidated financial statements.

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Merchants Bancshares, Inc.

Consolidated Statements of Income

	Years Ended December 31,
(In thousands except share and per share data)	2009	2008	2007
INTEREST AND DIVIDEND INCOME:
Interest and fees on loans	$     47,646	$     46,611	$     47,269
Investment income:
Interest on debt securities	18,587	21,392	15,096
Dividends	--	228	352
Interest on fed funds sold, short term investments and
interest bearing deposits	107	351	1,882
Total interest and dividend income	66,340	68,582	64,599
INTEREST EXPENSE:
Savings, NOW and money market accounts	1,901	3,876	4,779
Time deposits $100 thousand and greater	2,321	2,826	2,816
Other time deposits	5,383	9,544	10,365
Securities sold under agreement to repurchase and other short-term debt	641	1,686	3,503
Long-term debt	5,978	6,997	4,923
Total interest expense	16,224	24,929	26,386
Net interest income	50,116	43,653	38,213
Provision for credit losses	4,100	1,525	1,150
Net interest income after provision for credit losses	46,016	42,128	37,063
NONINTEREST INCOME:
Trust company income	1,724	1,831	1,957
Service charges on deposits	5,671	5,437	5,474
Net gains (losses) on investment securities	1,219	(287)	(97)
Equity in losses of real estate limited partnerships	(2,049)	(1,849)	(1,484)
Other	3,750	3,526	3,494
Total noninterest income	10,315	8,658	9,344
NONINTEREST EXPENSES:
Salaries and wages	14,510	13,730	12,211
Employee benefits	4,348	3,873	3,421
Occupancy expense	3,579	3,440	3,252
Equipment expense	2,826	2,642	2,761
Legal and professional fees	2,499	2,449	2,411
Marketing	1,470	1,652	1,199
State franchise taxes	1,142	1,066	992
FDIC Insurance	1,964	356	101
FHLB prepayment penalty	1,548	--	--
Other	6,212	5,893	5,940
Total noninterest expenses	40,098	35,101	32,288
Income before provision for income taxes	16,233	15,685	14,119
Provision for income taxes	3,754	3,768	3,261
NET INCOME	$     12,479	$     11,917	$     10,858
Basic earnings per common share	$         2.04	$         1.96	$         1.77
Diluted earnings per common share	$         2.04	$         1.96	$         1.76
Weighted average common shares outstanding	6,105,909	6,069,653	6,148,494
Weighted average diluted shares outstanding	6,107,389	6,079,274	6,164,441

See accompanying notes to consolidated financial statements.

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Merchants Bancshares, Inc.

Consolidated Statements of Comprehensive Income

	Years Ended December 31,
(In thousands)	2009	2008	2007
Net income	$  12,479	$  11,917	$  10,858
Other comprehensive income, net of tax:
Change in net unrealized gain on securities available for sale,      net of taxes of $2,355; $1,123, and $1,911	4,373	2,086	3,548
Reclassification adjustments for net securities (gains) losses included in      net income, net of taxes of $(427), $101, and $34	(792)	186	63
Change in net unrealized loss on interest rate swaps, net of taxes      of $15, $(244), and $0	28	(453)	--
Pension liability adjustment, net of taxes      of $239, $(845), and $229	456	(1,582)	426
Other comprehensive income	4,065	237	4,037
Comprehensive income	$  16,544	$  12,154	$  14,895

See accompanying notes to consolidated financial statements.

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