MERCHANTS BANCSHARES INC - FORM 10-Q

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EX-32.2 - EX-32.2 - MERCHANTS BANCSHARES INC	mbvt-20160630ex322d272f1.htm
EX-32.1 - EX-32.1 - MERCHANTS BANCSHARES INC	mbvt-20160630ex321c132f9.htm
EX-31.2 - EX-31.2 - MERCHANTS BANCSHARES INC	mbvt-20160630ex31242adac.htm
EX-31.1 - EX-31.1 - MERCHANTS BANCSHARES INC	mbvt-20160630ex3117a329b.htm
EX-10.1 - EX-10.1 - MERCHANTS BANCSHARES INC	mbvt-20160630ex1019bdf62.htm

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q


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

For the quarterly period ended June 30, 2016


[ ]	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	(I.R.S. Employer
incorporation or organization)	Identification No.)

275 Kennedy Drive, South Burlington, VT	05403
(Address of principal executive offices)	(Zip Code)

802-658-3400

(Registrant’s telephone number, including area code)

Not Applicable

(Former name, former address and former fiscal year, if changed since last report)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). [X] Yes [ ] No

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

Large Accelerated Filer [ ]

Accelerated Filer [ X ]

Nonaccelerated Filer [ ]

Smaller Reporting Company [ ]

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

As of July 18, 2016, there were 6,873,936 shares of the registrant’s common stock, par value $0.01 per share, outstanding.

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MERCHANTS BANCSHARES, INC. AND SUBSIDIARIES

FORM 10-Q

TABLE OF CONTENTS

		Page Reference
PART I	FINANCIAL INFORMATION
Item 1	Financial Statements	3
	Consolidated Balance Sheets (Unaudited)	3
	Consolidated Statements of Income (Unaudited)	4
	Consolidated Statements of Comprehensive Income (Unaudited)	5
	Consolidated Statements of Cash Flows (Unaudited)	6
	Notes to Interim Unaudited Consolidated Financial Statements	7
Item 2	Management’s Discussion and Analysis of Financial Condition and Results of Operations	34
Item 3	Quantitative and Qualitative Disclosures about Market Risk	49
Item 4	Controls and Procedures	52

PART II	OTHER INFORMATION
Item 1	Legal Proceedings	53
Item 1a	Risk Factors	53
Item 2	Unregistered Sales of Equity Securities and Use of Proceeds	53
Item 3	Defaults on Senior Securities	53
Item 4	Mine Safety Disclosure	53
Item 5	Other Information	53
Item 6	Exhibits	54
	Signatures	55

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MERCHANTS BANCSHARES, INC.

PART I – FINANCIAL INFORMATION

Item 1 – Financial Statements

Merchants Bancshares, Inc.

Consolidated Balance Sheets

(Unaudited)


	June 30,		December 31,
(In thousands except share and per share data)	2016		2015
ASSETS
Cash and due from banks	$	29,469	$	30,605
Interest earning deposits with banks and other short-term investments		30,053		119,578
Total cash and cash equivalents		59,522		150,183
Investments:
Securities available for sale, at fair value (amortized cost of $274,414 and $283,185)		280,078		283,454
Securities held to maturity (fair value of $114,591 and $120,093)		111,070		119,674
Total investments		391,148		403,128
Loans		1,395,393		1,414,280
Less: Allowance for loan losses		12,420		12,040
Net loans		1,382,973		1,402,240
Federal Home Loan Bank stock		7,036		3,797
Bank premises and equipment, net		14,052		15,030
Investment in real estate limited partnerships		5,768		5,687
Bank owned life insurance		10,659		10,551
Core deposit intangible		1,258		1,360
Goodwill		6,872		6,967
Other assets		19,422		22,294
Total assets	$	1,898,710	$	2,021,237
LIABILITIES
Deposits:
Demand (noninterest bearing)	$	606,200	$	631,244
Savings, interest bearing checking and money market accounts		627,883		665,623
Time deposits		219,247		254,572
Total deposits		1,453,330		1,551,439
Short-term borrowings		70,000		—
Securities sold under agreement to repurchase, short-term		184,920		286,639
Other long-term debt		3,694		5,238
Junior subordinated debentures issued to unconsolidated subsidiary trust		20,619		20,619
Other liabilities		9,854		9,248
Total liabilities		1,742,417		1,873,183
STOCKHOLDERS' EQUITY
Preferred stock
Class A non-voting shares authorized - 200,000, none outstanding		—		—
Class B voting shares authorized - 1,500,000, none outstanding		—		—
Common stock, $.01 par value		72		72
Authorized: 10,000,000 shares; Issued: 7,174,364 at June 30, 2016 and 7,168,869 at December 31, 2015
Outstanding: 6,871,642 at June 30, 2016 and 6,855,294 at December 31, 2015
Capital in excess of par value		55,297		55,063
Retained earnings		110,233		106,219
Treasury stock, at cost: 582,989 shares including 280,267 shares held by the Compensation Plan for Directors and Trustees at June 30, 2016 and 612,935 shares including 299,360 shares held by the Compensation Plan for Directors and Trustees at December 31, 2015		(13,407)		(13,798)
Deferred compensation arrangements: 280,267 shares at June 30, 2016 and 299,360 shares at December 31, 2015		6,140		6,521
Accumulated other comprehensive (loss) income		(2,042)		(6,023)
Total stockholders' equity		156,293		148,054
Total liabilities and stockholders' equity	$	1,898,710	$	2,021,237

See accompanying notes to unaudited consolidated financial statements

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Merchants Bancshares, Inc.

Consolidated Statements of Income

(Unaudited)


	Three Months Ended				Six Months Ended
	June 30,				June 30,
(In thousands except per share data)	2016		2015		2016		2015
INTEREST AND DIVIDEND INCOME
Interest and fees on loans	$	12,897	$	10,800	$	25,701	$	21,423
Investment income:
Interest and dividends on investment securities		1,988		1,913		3,985		3,823
Interest on interest earning deposits with banks and other short-term investments		58		59		139		132
Total interest and dividend income		14,943		12,772		29,825		25,378
INTEREST EXPENSE
Savings, interest bearing checking and money market accounts		424		354		864		721
Time deposits		340		323		731		657
Short-term borrowings		31		5		31		5
Securities sold under agreement to repurchase, short-term		103		146		212		301
Long-term debt		214		199		424		396
Total interest expense		1,112		1,027		2,262		2,080
Net interest income		13,831		11,745		27,563		23,298
Provision for credit losses		200		100		405		100
Net interest income after provision for credit losses		13,631		11,645		27,158		23,198
NONINTEREST INCOME
Trust division income		835		885		1,702		1,780
Net debit card income		812		812		1,461		1,505
Overdraft income		677		333		1,308		779
Service charges on deposits		424		378		839		718
Other		473		345		835		641
Total noninterest income		3,221		2,753		6,145		5,423
NONINTEREST EXPENSE
Compensation and benefits		5,456		5,190		11,764		10,238
Occupancy expense		1,025		1,049		2,164		2,192
Equipment expense		704		732		1,423		1,498
Telephone expense		192		186		390		403
Legal and professional fees		731		537		1,324		974
Mobile & internet banking		336		410		702		796
Core / Item processing		459		433		976		839
Marketing		207		137		399		289
State franchise taxes		398		404		796		690
FDIC insurance		281		217		535		435
Merger costs		(72)		143		61		148
Core deposit intangible		51		—		102		—
Other		1,065		1,043		2,116		1,986
Total noninterest expense		10,833		10,481		22,752		20,488
Income before provision for income taxes		6,019		3,917		10,551		8,133
Provision for income taxes		1,653		801		2,695		1,681
NET INCOME	$	4,366	$	3,116	$	7,856	$	6,452

Basic earnings per common share	$	0.64	$	0.49	$	1.15	$	1.02
Diluted earnings per common share	$	0.63	$	0.49	$	1.14	$	1.02

See accompanying notes to unaudited consolidated financial statements

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Merchants Bancshares, Inc.

Consolidated Statements of Comprehensive Income

(Unaudited)


	Three Months Ended				Six Months Ended
	June 30,				June 30,
(In thousands)	2016		2015		2016		2015
Net income	$	4,366	$	3,116	$	7,856	$	6,452
Other comprehensive income, net of tax:
Unrealized holding gain on securities available for sale, net of taxes of $477, $(575), $1,888 and $(153)		883		(1,065)		3,507		(282)
Amortization of unrealized holding losses of securities transferred from available for sale to held to maturity, net of taxes of $66, $69, $134 and $136		121		128		248		252
Change in net unrealized loss on interest rate swaps, net of taxes of $22, $0, $41 and $11		41		—		76		21
Pension liability adjustment, net of taxes of $41, $36, $82 and $72		75		67		150		134
Other comprehensive income		1,120		(870)		3,981		125
Comprehensive income	$	5,486	$	2,246	$	11,837	$	6,577

See accompanying notes to unaudited consolidated financial statements

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Merchants Bancshares, Inc.

Consolidated Statements of Cash Flows

(Unaudited)


	Six Months Ended June 30,
(In thousands)	2016		2015
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	7,856	$	6,452
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for credit losses		405		100
Depreciation and amortization		1,078		1,089
Amortization of investment security premiums and accretion of discounts, net		603		581
Amortization of deferred loan costs		326		231
Amortization of core deposit intangible		102		—
Stock based compensation		166		65
Deferred (gain) on sale of premises		(258)		(258)
Equity in losses of real estate limited partnerships, net		786		564
Increase in cash surrender value of bank owned life insurance		(108)		(121)
Changes in assets and liabilities:
Net change in interest receivable		660		652
Net change in other assets		355		1,776
Net change in interest payable		(86)		(54)
Net change in other liabilities		1,131		359
Net cash provided by operating activities		13,016		11,436
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from maturities of investment securities available for sale		23,575		21,696
Proceeds from maturities of investment securities held to maturity		8,855		9,351
Purchases of investment securities available for sale		(15,277)		(78,648)
Loan originations in excess of principal payments		18,472		(21,575)
Purchases of Federal Home Loan Bank stock, net		(3,239)		—
Real estate limited partnership investments		(827)		(1,266)
Purchases of bank premises and equipment		(100)		(827)
Net cash provided by (used in) investing activities		31,459		(71,269)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net change in deposits		(98,109)		38,053
Net decrease in securities sold under agreement to repurchase and other short-term borrowing		(31,719)		(88,505)
Principal payments on long-term debt		(1,544)		(41)
Cash dividends paid		(3,842)		(3,545)
Increase in deferred compensation arrangements		299		157
Tax benefit from exercise of stock options and distribution of shares in deferred compensation arrangements		(221)		(100)
Net cash (used in) financing activities		(135,136)		(53,981)
Increase (decrease) in cash and cash equivalents		(90,661)		(113,814)
Cash and cash equivalents beginning of period		150,183		154,459
Cash and cash equivalents end of period	$	59,522	$	40,645

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Total interest payments	$	2,348	$	2,134
Total income tax payments		366		—
SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES
Distribution of stock under deferred compensation arrangements	$	559	$	514
Non-cash exercise of stock options		—		626

See accompanying notes to unaudited consolidated statements

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Notes To Interim Unaudited Consolidated Financial Statements

For additional information, see the Merchants Bancshares, Inc. Annual Report on Form 10-K for the fiscal year ended December 31, 2015, filed with the Securities and Exchange Commission (the “SEC”) on March 14, 2016.

NOTE 1: FINANCIAL STATEMENT PRESENTATION

Principles of Consolidation

The accompanying consolidated financial statements include the accounts of Merchants Bancshares, Inc. (the “Company”), and its wholly-owned subsidiary Merchants Bank (the “Bank,” and collectively with the Company, “Merchants”, “we,” “us, or “our”). All material intercompany accounts and transactions are eliminated in consolidation. We offer a full range of deposit, loan, cash management, and trust services to meet the financial needs of individual consumers, businesses and municipalities at 31 full-service banking offices throughout the state of Vermont and one full-service banking office in Massachusetts as of June 30, 2016.

Basis of Presentation

The accompanying unaudited interim consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and the instructions to the Quarterly Report on Form 10-Q and Rule 10-01 of Regulation S-X promulgated under the Securities Exchange Act of 1934, as amended. Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements. All adjustments necessary for a fair presentation of our interim consolidated financial statements as of June 30, 2016 and December 31, 2015 and for the three and six months ended June 30, 2016 and 2015 have been included. The information was prepared from our unaudited financial statements and the unaudited financial statements of our subsidiaries, Merchants Bank and MBVT Statutory Trust I. Amounts reported for prior periods are reclassified, where necessary, to be consistent with the current period presentation.

Management’s Use of Estimates in Preparation of Financial Statements

The preparation of financial statements in conformity with U.S. Generally Accepted Accounting Principles (“GAAP”) requires Management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of income and expenses during the reporting periods. The most significant estimates include those used in determining the allowance for credit losses, income taxes, interest income recognition on loans and investments and analysis of other-than-temporary impairment of our investment securities portfolio. Operating results in the future may vary from the amounts derived from Management's estimates and assumptions.

NOTE 2: RECENT ACCOUNTING PRONOUNCEMENTS

Accounting Standards Update (ASU) 2016-13 – Credit Losses – This Update will provide financial statement users with more decision-useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date. To achieve this objective, the amendments in this Update replace the incurred loss impairment methodology in current GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. The amendments in this Update are effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. The Company is currently evaluating the impact of this new requirement on the consolidated financial statements.

ASU 2016-09 – Stock Compensation – This Update simplifies the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification in the statement of cash flows. The update requires all excess tax benefits and tax deficiencies related to share-based awards to

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be recognized as income tax expense or benefit in the income statement. In addition, the update includes changes to the classification of excess tax benefits on the statement of cash flows, an election related to the accounting for forfeitures, minimum statutory tax withholding requirements, as well as the classification of employee taxes paid on the statement of cash flows when an employer withholds shares for tax-withholding purposes. The guidance is effective for fiscal years beginning after December 15, 2016, including the interim periods. The Company is currently evaluating the impact of this new requirement on the consolidated financial statements.

ASU 2016-02 – Leases – This Update increases the transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. For lessees, all leases will be required to be recognized on the balance sheet by recording a right-of-use asset and a lease liability. The accounting applied by a lessor is largely unchanged from that applied under the existing guidance. The ASU requires additional qualitative and quantitative disclosures with the objective of enabling users of financial statements to assess the amount, timing, and uncertainty of cash flows arising from leases. The guidance is effective for fiscal years beginning after December 15, 2018, including the interim periods. The Company is currently evaluating the impact of this new requirement on the consolidated financial statements.

ASU 2014-09 – Revenue from Contracts with Customers – In May 2014, the Financial Accounting Standards Board (FASB) amended existing guidance related to revenue from contracts with customers. This amendment supersedes and replaces nearly all existing revenue recognition guidance, including industry-specific guidance, establishes a new control-based revenue recognition model, changes the basis for deciding when revenue is recognized over time or at a point in time, provides new and more detailed guidance on specific topics and expands and improves disclosures about revenue. In addition, this amendment specifies the accounting for some costs to obtain or fulfill a contract with a customer. These amendments are effective for annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period. Early application is permitted only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that period. The amendments should be applied retrospectively to all periods presented or retrospectively with the cumulative effect recognized at the date of initial application. The Company is currently evaluating the impact of this new requirement on the consolidated financial statements.

NOTE 3: ACQUISITION OF NUVO BANK & TRUST COMPANY

On December 4, 2015, the Company completed the acquisition of NUVO Bank & Trust Company (“NUVO”), Springfield, Massachusetts. NUVO's banking business operates as a division of Merchants Bank. Total consideration paid by Merchants for NUVO's outstanding stock comprised 517,109 shares of common stock and $5.109 million in cash. Merchants also paid an aggregate of $878,718 to cash out NUVO stock options and a portion of its common stock warrants and issued replacement warrants to purchase an aggregate of 90,474 shares of Merchants common stock on adjusted terms, consisting of warrants expiring in 2017 to purchase 56,104 shares at an exercise price of $20.69 and warrants expiring in 2018 to purchase 34,370 shares at an exercise price of $41.39 per share. The results of NUVO’s operations are included in the Company’s unaudited consolidated statements of income for the period ended June 30, 2016.

The acquisition of NUVO expands the Company’s New England footprint beyond Vermont and into the Springfield and greater Western Massachusetts commercial banking market. The Company now has 32 banking locations, including the new office in Springfield, Massachusetts.

The acquisition of NUVO was accounted for using the acquisition method of accounting and, accordingly, assets acquired, liabilities assumed and consideration paid were recorded at their estimated fair values as of the acquisition date. The excess of consideration paid of $6.872 million over the fair value of net assets acquired has been reported as goodwill in the Company’s unaudited consolidated statements of financial condition as of June 30, 2016. Goodwill created in the acquisition is not deductible for income tax purposes. This goodwill consists largely of the synergies and cost savings arising from the combining of the operations of the two companies.

The assets acquired and liabilities assumed in the acquisition of NUVO were recorded at their preliminary estimated fair values based on management’s best estimates using information available at the date of the acquisition and are subject to adjustment.

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In connection with the acquisition, the consideration paid and the fair value of identifiable assets acquired and liabilities assumed as of the date of acquisition are summarized in the following table:


(In thousands)
Consideration paid:
Common stock issued in exchange for NUVO shares	$	16,889
Cash paid for NUVO shares		5,988
Stock warrants issued		470
Total consideration paid	$	23,347

Assets acquired:
Cash and cash equivalents	$	7,070
Interest bearing time deposits with banks		110
Investments		4,365
Restricted investment in bank stock		376
Loans		149,360
Premises and equipment , net		580
Accrued interest receivable		369
Core deposit intangible		1,377
Deferred tax asset		1,926
Other assets		355
Total assets acquired		165,888
Liabilities assumed:
Deposits		144,482
Federal Home Loan Bank advances		4,001
Accrued interest payable		42
Tax effect of acquisition fair value adjustments		705
Other liabilities		183
Total liabilities assumed		149,413
Net assets acquired	$	16,475

Goodwill	$	6,872

The following table details the changes in fair value of the consideration paid and the net assets acquired as of December 4, 2015 from the amounts originally reported in the Company’s Form 10-K for the year ended December 31, 2015:


(In thousands)
Goodwill reported as of December 31, 2015	$	6,967

Effect of adjustments to:
Consideration paid:
Stock warrants issued		(74)
Assets acquired:
Investments		21
Adjusted goodwill as of June 30, 2016	$	6,872

The changes to goodwill during the six months ended June 30, 2016 are primarily due to changes in the final market value for assets acquired and consideration paid. In many cases, the fair values of assets acquired and liabilities assumed were determined by estimating the cash flows expected to result from those assets and liabilities and discounting them at appropriate market rates. These changes had no impact on current quarter or previously reported income.

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NOTE 4: GOODWILL AND INTANGIBLE ASSETS

The goodwill and intangible balances presented below resulted from the Company’s acquisition of NUVO. The acquisition of NUVO resulted in goodwill of $6.872 million and Core Deposit Intangible (CDI) of $1.377 million. For further information regarding goodwill and other intangible assets recorded in connection with the acquisition of NUVO, including the effect of adjustments to goodwill, please refer to Note 3.

Goodwill

Goodwill is deemed to have an indefinite life and therefore is not amortized, but is instead subject to impairment tests. There was no impairment for the three and six months ended June 30, 2016 or the period from the date of the acquisition through December 31, 2015.


	June 30,		December 31,
(In thousands)	2016		2015
Beginning of period	$	6,967	$	—
Effect of adjustments		(95)		—
Goodwill		—		6,967
Impairment		—		—
End of period	$	6,872	$	6,967

Other Intangible Assets

Acquired CDI were as follows:


		June 30,		December 31,
(In thousands)		2016		2015
Beginning of period	$	1,360	$	—
Additions		—		1,377
Amortization		102		17
End of period	$	1,258	$	1,360

The CDI recognized in 2015 was related to the acquisition of NUVO. Aggregate amortization expense for the CDI was $51 thousand and $102 thousand for the three and six months ended June 30, 2016, respectively and $17 thousand for the period from the date of the acquisition through December 31, 2015.

The estimated amortization expense for each of the next five years:


(In thousands)		Amount
Remainder of 2016	$	102
2017		173
2018		147
2019		126
2020		120
2021		120
Thereafter		470

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NOTE 5: INVESTMENT SECURITIES

Investments in securities are classified as available for sale or held to maturity as of June 30, 2016 and December 31, 2015. The amortized cost and fair values of the securities classified as available for sale and held to maturity as of June 30, 2016 are as follows:


			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
(In thousands)	Cost		Gains		Losses		Value
Available for Sale:
U.S. Treasury Obligations	$	25,072	$	353	$	—	$	25,425
U.S. Government Sponsored Enterprises ("U.S. GSEs")		41,246		704		—		41,950
Federal Home Loan Bank ("FHLB") Obligations		40,078		1,014		—		41,092
Residential Real Estate Mortgage-backed Securities ("Agency MBSs")		85,668		2,506		(3)		88,171
Agency Commercial Mortgage Backed Securities ("Agency CMBSs")		24,342		366		—		24,708
Agency Collateralized Mortgage Obligations ("Agency CMOs")		57,707		719		(32)		58,394
Asset Backed Securities ("ABSs")		301		37		—		338
Total Available for Sale	$	274,414	$	5,699	$	(35)	$	280,078


			Gross		Gross
	Amortized		Unrecognized		Unrecognized		Fair
	Cost		Gains		Losses		Value
Held to Maturity:
U.S. Agency Obligations	$	18,964	$	971	$	—	$	19,935
U.S. GSEs		9,585		416		—		10,001
FHLB Obligations		4,777		224		—		5,001
Agency CMOs		71,228		1,634		(42)		72,820
Agency MBSs		6,516		318		—		6,834
Total Held to Maturity	$	111,070	$	3,563	$	(42)	$	114,591

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The amortized cost and fair values of the securities classified as available for sale and held to maturity as of December 31, 2015 are as follows:


			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
(In thousands)	Cost		Gains		Losses		Value
Available for Sale:
U.S. Treasury Obligations	$	25,064	$	61	$	(12)	$	25,113
U.S. GSEs		20,895		3		(104)		20,794
FHLB Obligations		51,230		107		(226)		51,111
Agency MBSs		96,073		1,688		(512)		97,249
Agency CMBSs		24,950		—		(397)		24,553
Agency CMOs		64,648		74		(443)		64,279
ABSs		325		30		—		355
Total Available for Sale	$	283,185	$	1,963	$	(1,694)	$	283,454


			Gross		Gross
	Amortized		Unrecognized		Unrecognized		Fair
	Cost		Gains		Losses		Value
Held to Maturity:
U.S. Agency Obligations	$	20,084	$	486	$	—	$	20,570
U.S. GSEs		9,556		166		—		9,722
FHLB Obligations		4,758		76		—		4,834
Agency CMOs		78,249		253		(716)		77,786
Agency MBSs		7,027		154		—		7,181
Total Held to Maturity	$	119,674	$	1,135	$	(716)	$	120,093

The contractual final maturity distribution of the debt securities classified as available for sale as of June 30, 2016, are as follows:


									Securities
			After One		After Five				not due
	Within		But Within		But Within		After Ten		at a Single
(In thousands)	One Year		Five Years		Ten Years		Years		Maturity		Total
Available for Sale (at fair value):
U.S. Treasury Obligations	$	101	$	25,324	$	—	$	—	$	N/A	$	25,425
U.S. GSEs		—		41,950		—		—		N/A		41,950
FHLB Obligations		—		29,413		11,679		—		N/A		41,092
Agency MBSs		N/A		N/A		N/A		N/A		88,171		88,171
Agency CMBSs		N/A		N/A		N/A		N/A		24,708		24,708
Agency CMOs		N/A		N/A		N/A		N/A		58,394		58,394
ABSs		N/A		N/A		N/A		N/A		338		338
Total Available for Sale	$	101	$	96,687	$	11,679	$	—	$	171,611	$	280,078
Available for Sale (at amortized cost):
U.S. Treasury Obligations	$	101	$	24,971	$	—	$	—	$	N/A	$	25,072
U.S. GSEs		—		41,246		—		—		N/A		41,246
FHLB Obligations		—		28,882		11,196		—		N/A		40,078
Agency MBSs		N/A		N/A		N/A		N/A		85,668		85,668
Agency CMBSs		N/A		N/A		N/A		N/A		24,342		24,342
Agency CMOs		N/A		N/A		N/A		N/A		57,707		57,707
ABSs		N/A		N/A		N/A		N/A		301		301
Total Available for Sale	$	101	$	95,099	$	11,196	$	—	$	168,018	$	274,414

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The contractual final maturity distribution of the debt securities classified as held to maturity as of June 30, 2016, are as follows:


									Securities
			After One		After Five				not due
	Within		But Within		But Within		After Ten		at a Single
(In thousands)	One Year		Five Years		Ten Years		Years		Maturity		Total
Held to Maturity (at fair value):
U.S. Agency Obligations	$	—	$	—	$	—	$	19,935	$	N/A	$	19,935
U.S. GSEs		—		—		10,001		—		N/A		10,001
FHLB Obligations		—		—		5,001		—		N/A		5,001
Agency CMOs		N/A		N/A		N/A		N/A		72,820		72,820
Agency MBSs		N/A		N/A		N/A		N/A		6,834		6,834
Total Held to Maturity	$	—	$	—	$	15,002	$	19,935	$	79,654	$	114,591
Held to Maturity (at amortized cost):
U.S. Agency Obligations	$	—	$	—	$	—	$	18,964	$	N/A	$	18,964
U.S. GSEs		—		—		9,585		—		N/A		9,585
FHLB Obligations		—		—		4,777		—		N/A		4,777
Agency CMOs		N/A		N/A		N/A		N/A		71,228		71,228
Agency MBSs		N/A		N/A		N/A		N/A		6,516		6,516
Total Held to Maturity	$	—	$	—	$	14,362	$	18,964	$	77,744	$	111,070

Actual maturities will differ from contractual maturities because borrowers may have rights to call or prepay obligations.

For the six months ended June 30, 2016 and 2015, we did not record any securities gains or losses related to the sale of securities.

Securities with a carrying value of $321.13 million and $335.81 million at June 30, 2016 and December 31, 2015, respectively, were pledged to secure public deposits, securities sold under agreements to repurchase, and for other purposes required by law.

Gross unrealized losses on investment securities and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in continuous unrealized loss position, at June 30, 2016, were as follows:


	Less Than 12 Months					12 Months or More					Total
	Number	Fair				Number	Fair				Number	Fair
(In thousands)	of Issues	Value		Loss		of Issues	Value		Loss		of Issues	Value		Loss
Available for Sale:
FHLB Obligations	—	$	—	$	—	—	$	—	$	—	—	$	—	$	—
Agency MBSs	4		1,113		(3)	—		—		—	4		1,113		(3)
Agency CMBSs	—		—		—	—		—		—	—		—		—
Agency CMOs	—		—		—	2		2,662		(32)	2		2,662		(32)
ABSs	—		—		—	—		—		—	—		—		—
Total Available for Sale	4	$	1,113	$	(3)	2	$	2,662	$	(32)	6	$	3,775	$	(35)
Held to Maturity:
Agency CMOs	—	$	—	$	—	1	$	3,474	$	(42)	—	$	3,474	$	(42)
Total Held to Maturity	—	$	—	$	—	1	$	3,474	$	(42)	—	$	3,474	$	(42)

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	Less Than 12 Months					12 Months or More					Total
	Number	Fair				Number	Fair				Number	Fair
(In thousands)	of Issues	Value		Loss		of Issues	Value		Loss		of Issues	Value		Loss
Available for Sale:
U.S. Treasury Obligations	3	$	15,068	$	(12)	—	$	—	$	—	3	$	15,068	$	(12)
U.S. GSEs	3		14,817		(104)	—		—		—	3		14,817		(104)
FHLB Obligations	8		39,094		(226)	—		—		—	8		39,094		(226)
Agency MBSs	17		60,748		(512)	—		—		—	17		60,748		(512)
Agency CMBSs	5		19,608		(331)	1		4,761		(66)	6		24,369		(397)
Agency CMOs	15		42,235		(283)	3		6,089		(160)	18		48,324		(443)
Total Available for Sale	51	$	191,570	$	(1,468)	4	$	10,850	$	(226)	55	$	202,420	$	(1,694)
Held to Maturity:
Agency CMOs	14	$	51,713	$	(623)	2	$	5,287	$	(93)	16	$	57,000	$	(716)
Total Held to Maturity	14	$	51,713	$	(623)	2	$	5,287	$	(93)	16	$	57,000	$	(716)

There were no securities classified as trading at June 30, 2016 and December 31, 2015.

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

At June 30, 2016, all of our MBSs and CMOs held were issued by U.S. government-sponsored entities and agencies, primarily the Federal National Mortgage Association (“FNMA”) and Federal Home Loan Mortgage Corporation (“FHLMC”), institutions which the government has affirmed its commitment to support. Because the decline in fair value is attributable to changes in interest rates and illiquidity, and not credit quality, and because we do not have the intent to sell these securities and it is not likely that we will be required to sell the securities before their anticipated recovery, we do not consider these securities to be other-than-temporarily impaired at June 30, 2016.

Agency MBSs and Agency CMOs consist of pools of residential mortgages which are guaranteed by FNMA, FHLMC, or Government National Mortgage Association (“GNMA”) with various origination dates and maturities. Agency CMBS consists of bonds backed by commercial real estate which are guaranteed by FNMA and GNMA.

During the first quarter of 2014, we transferred securities with a total amortized cost of $12.63 million, and a corresponding fair value of $12.64 million, from available for sale to held to maturity. The net unrealized gain, net of taxes, on these securities at the dates of the transfers was $8 thousand. During the third and fourth quarters of 2013, we transferred securities with a total amortized cost of $152.89 million, and a corresponding fair value of $147.45 million, from available for sale to held to maturity. The net unrealized holding loss, net of taxes, on these securities at the dates of the transfers was $3.53 million. The unrealized holding gains and losses at the time of transfer continues to be reported in accumulated other comprehensive income, net of tax and are amortized over the remaining lives of the securities as an adjustment of the yield. The amortization of the unamortized holding gains and losses reported in accumulated other comprehensive income will offset the effect on interest income of the premium and discount for the transferred securities. The remaining unamortized balance of the net losses for the securities transferred from available for sale to held to maturity was $3.17 million or $2.05 million, net of tax at June 30, 2016.

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NOTE 6: SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE

The following table presents the contractual maturity of our secured borrowings and class of collateral pledged:


	At June 30, 2016
	Remaining Contractual Maturity of the Agreements
	Overnight and						Greater Than
(In thousands)	Continuous		Up to 30 Days		30-90 Days		90 Days		Total
Repurchase Agreements:
Available for Sale:
U.S. Treasury Obligations	$	22,320	$	—	$	—	$	—	$	22,320
U.S. GSEs		12,191		—		—		—		12,191
FHLB Obligations		34,476		—		—		—		34,476
Agency MBSs		24,798		—		—		—		24,798
Agency CMBSs		11,325		—		—		—		11,325
Agency CMOs		12,822		—		—		—		12,822
Total Available for Sale	$	117,932	$	—	$	—	$	—	$	117,932

(In thousands)
Held to Maturity:
U.S. Agency Obligations	$	12,134	$	—	$	—	$	—	$	12,134
Agency CMOs		40,743		—		—		—		40,743
Agency MBSs		14,111		—		—		—		14,111
Total Held to Maturity	$	66,988	$	—	$	—	$	—	$	66,988

The fair value of securities pledged to secure repurchase agreements may decline. The Company manages this risk by having a policy to pledge securities valued above the gross outstanding balance of repurchase agreements. Securities sold under agreements to repurchase are secured by securities with a carrying value of $185.04 million at June 30, 2016 and $287.27 million at December 31, 2015.

NOTE 7: LOANS AND THE ALLOWANCE FOR CREDIT LOSSES

Loans

The composition of our loan portfolio at June 30, 2016 and December 31, 2015 was as follows:


(In thousands)	June 30, 2016		December 31, 2015
Commercial, financial and agricultural	$	260,167	$	237,451
Municipal loans		60,590		105,421
Real estate loans – residential		456,132		468,443
Real estate loans – commercial		560,056		558,004
Real estate loans – construction		50,788		34,802
Installment loans		7,629		10,115
All other loans		31		44
Total loans	$	1,395,393	$	1,414,280

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We primarily originate commercial, commercial real estate, municipal, and residential real estate loans to customers throughout the states of Vermont and Massachusetts. There are no significant industry concentrations in the loan portfolio. Total loans included $1.14 million and $1.20 million of net deferred loan origination costs at June 30, 2016 and December 31, 2015, respectively. The aggregate amount of overdrawn deposit balances classified as loan balances was $344 thousand and $308 thousand at June 30, 2016 and December 31, 2015, respectively.

The following table reflects our loan loss experience and activity in the allowance for loan losses for the three months ended June 30, 2016:


	Commercial,
	financial				Real		Real		Real
	and				estate-		estate-		estate-
(In thousands)	agricultural		Municipal		residential		commercial		construction		Installment		All other		Totals
Allowance for loan losses:
Beginning balance	$	2,856	$	622	$	2,857	$	5,281	$	465	$	92	$	—	$	12,173
Charge-offs		(4)		—		—		—		—		(36)		—		(40)
Recoveries		2		—		11		—		—		20		—		33
Provision (credit)		344		(270)		(59)		142		84		13		—		254
Ending balance	$	3,198	$	352	$	2,809	$	5,423	$	549	$	89	$	—	$	12,420

The $254 thousand provision for loan losses includes a $200 thousand provision for credit losses plus $54 thousand of excess reserves from the reserve for undisbursed lines and letters.

The following table reflects our loan loss experience and activity in the allowance for loan losses for the three months ended June 30, 2015:


	Commercial,
	financial				Real		Real		Real
	and				estate-		estate-		estate-
(In thousands)	agricultural		Municipal		residential		commercial		construction		Installment		All other		Totals
Allowance for loan losses:
Beginning balance	$	2,866	$	530	$	3,024	$	5,149	$	364	$	81	$	—	$	12,014
Charge-offs		(6)		—		—		—		—		(17)		—		(23)
Recoveries		14		—		26		—		—		10		—		50
Provision (credit)		51		(171)		(7)		150		113		(15)		—		121
Ending balance	$	2,925	$	359	$	3,043	$	5,299	$	477	$	59	$	—	$	12,162

The $121 thousand provision for loan losses includes a $100 thousand provision for credit losses plus $21 thousand of excess reserves to the reserve for undisbursed lines and letters.

The following table reflects our loan loss experience and activity in the allowance for loan losses for the six months ended June 30, 2016:


	Commercial,
	financial				Real		Real		Real
	and				estate-		estate-		estate-
(In thousands)	agricultural		Municipal		residential		commercial		construction		Installment		All other		Totals
Allowance for loan losses:
Beginning balance	$	2,696	$	590	$	2,882	$	5,386	$	420	$	66	$	—	$	12,040
Charge-offs		(7)		—		(73)		—		—		(78)		—		(158)
Recoveries		4		—		22		4		—		39		—		69
Provision (credit)		505		(238)		(22)		33		129		62		—		469
Ending balance	$	3,198	$	352	$	2,809	$	5,423	$	549	$	89	$	—	$	12,420

The $469 thousand provision for loan losses consists of a $405 thousand provision for credit losses outstanding plus $64 thousand of excess reserves from the reserve for undisbursed lines and letters.

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The following table reflects our loan loss experience and activity in the allowance for loan losses for the six months ended June 30, 2015:


	Commercial,
	financial				Real		Real		Real
	and				estate-		estate-		estate-
(In thousands)	agricultural		Municipal		residential		commercial		construction		Installment		All Other		Total
Allowance for loan losses:
Beginning balance	$	2,583	$	623	$	3,038	$	5,209	$	325	$	13	$	42	$	11,833
Charge-offs		(17)		—		(55)		—		—		(43)		—		(115)
Recoveries		28		—		29		1		—		33		—		91
Provision (credit)		331		(264)		31		89		152		56		(42)		353
Ending balance	$	2,925	$	359	$	3,043	$	5,299	$	477	$	59	$	—	$	12,162

The $353 thousand provision for loan losses a consists of a $100 thousand provision for credit losses plus $253 thousand of excess reserves from the reserve for undisbursed lines and letters.

The following presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment based upon impairment method at June 30, 2016:


	Commercial,
	financial and				Real estate-		Real estate-		Real estate-
(In thousands)	agricultural		Municipal		residential		commercial		construction		Installment		All other		Totals
Allowance for loan losses:
Ending balance individually evaluated for impairment	$	195	$	—	$	116	$	52	$	—	$	—	$	—	$	363
Ending balance collectively evaluated for impairment		3,003		352		2,693		5,371		549		89		—		12,057
Ending balance acquired with deteriorated credit quality		—		—		—		—		—		—		—		—
Totals	$	3,198	$	352	$	2,809	$	5,423	$	549	$	89	$	—	$	12,420
Financing receivables:
Ending balance individually evaluated for impairment	$	668	$	—	$	701	$	1,339	$	—	$	27	$	—	$	2,735
Ending balance collectively evaluated for impairment		258,824		60,590		455,431		556,742		50,788		7,602		31		1,390,008
Ending balance acquired with deteriorated credit quality		675		—		—		1,975		—		—		—		2,650
Totals	$	260,167	$	60,590	$	456,132	$	560,056	$	50,788	$	7,629	$	31	$	1,395,393

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The following presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment based upon impairment method at December 31, 2015:


	Commercial,
	financial and				Real estate-		Real estate-		Real estate-
(In thousands)	agricultural		Municipal		residential		commercial		construction		Installment		All other		Totals
Allowance for loan losses:
Ending balance individually evaluated for impairment	$	—	$	—	$	137	$	—	$	—	$	—	$	—	$	137
Ending balance collectively evaluated for impairment		2,696		590		2,745		5,386		420		66		—		11,903
Ending balance acquired with deteriorated credit quality		—		—				—		—		—		—		—
Totals	$	2,696	$	590	$	2,882	$	5,386	$	420	$	66	$	—	$	12,040
Financing receivables:
Ending balance individually evaluated for impairment	$	595	$	—	$	706	$	647	$	—	$	22	$	—	$	1,970
Ending balance collectively evaluated for impairment		235,652		105,421		467,737		555,323		34,802		10,093		44		1,409,072
Ending balance acquired with deteriorated credit quality		1,204		—		—		2,034		—		—		—		3,238
Totals	$	237,451	$	105,421	$	468,443	$	558,004	$	34,802	$	10,115	$	44	$	1,414,280

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The table below presents the recorded investment of loans segregated by class, with delinquency aging as of June 30, 2016:


	31-60		61-90		91 Days		Total
	Days		Days		or More		Past
(In thousands)	Past Due		Past Due		Past Due		Due		Current			Nonperforming	Total
Commercial, financial and agricultural	$	—	$	—	$	—	$	—	$	258,942	$	1,225	$	260,167
Municipal		—		—		—		—		60,590		—		60,590
Real estate-residential:
First mortgage		702		—		—		702		414,053		701		415,456
Second mortgage		—		—		—		—		40,676		—		40,676
Real estate-commercial:
Owner occupied		—		—		—		—		214,080		2,155		216,235
Non-owner occupied		—		—		—		—		343,240		581		343,821
Real estate-construction:
Residential		—		—		—		—		2,446		—		2,446
Commercial		—		—		—		—		48,342		—		48,342
Installment		72		—		—		72		7,530		27		7,629
Other		—		—		—		—		31		—		31
Total	$	774	$	—	$	—	$	774	$	1,389,930	$	4,689	$	1,395,393

Of the total nonperforming loans in the aging table above, $2.31 million are past due of which $386 thousand are restructured loans and $0 were 91 days or more past due and accruing.

The table below presents the recorded investment of loans segregated by class, with delinquency aging as of December 31, 2015:


	31-60		61-90		91 Days		Total
	Days		Days		or More		Past
(In thousands)	Past Due		Past Due		Past Due		Due		Current			Nonperforming	Total
Commercial, financial and agricultural	$	—	$	251	$	—	$	251	$	235,820	$	1,380	$	237,451
Municipal		—		—		—		—		105,421		—		105,421
Real estate-residential:
First mortgage		50		—		—		50		425,520		706		426,276
Second mortgage		—		8		—		8		42,159		—		42,167
Real estate-commercial:
Owner occupied		323		—		—		323		219,080		1,605		221,008
Non-owner occupied		—		—		—		—		336,514		482		336,996
Real estate-construction:
Residential		—		—		—		—		2,422		—		2,422
Commercial		—		—		—		—		32,380		—		32,380
Installment		61		9		—		70		10,023		22		10,115
Other		—		—		—		—		44		—		44
Total	$	434	$	268	$	—	$	702	$	1,409,383	$	4,195	$	1,414,280

Of the total nonperforming loans in the aging table above, $2.65 million are past due of which $471 thousand are restructured loans and $0 were 91 days or more past due and accruing.

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Impaired loans by class at June 30, 2016 and for the three and six months ended June 30, 2016 are as follows:


	Period Ended						Three Months Ended				Six Months Ended
	June 30, 2016						June 30, 2016				June 30, 2016
			Unpaid					Average	Interest			Average	Interest
	Recorded		Principal		Related			Recorded	Income			Recorded	Income
(In thousands)	Investment		Balance		Allowance			Investment	Recognized			Investment	Recognized
With no related allowance recorded
Commercial, financial and agricultural	$	97	$	97	$	—	$	99	$	1	$	245	$	2
Residential:
First mortgage		220		282		—		213		1		227		3
Second mortgage		—		—		—		—		—		1		—
Commercial Real Estate:
Owner occupied		698		691		—		623		—		512		—
Non-owner occupied		581		595		—		587		—		529		—
Construction:
Residential		—		—		—		—		—		—		—
Commercial		—		—		—		—		—		—		—
Installment		27		27		—		10		—		9		—
With related allowance recorded
Commercial, financial and agricultural		571		576		195		508		—		381		—
Residential:
First mortgage		481		496		116		421		—		423		—
Second mortgage		—		—		—		—		—		—		—
Commercial Real Estate:
Owner occupied		60		59		52		40		—		20		—
Total
Commercial, financial and agricultural		668		673		195		607		1		626		2
Residential		701		778		116		634		1		651		3
Commercial Real Estate		1,339		1,345		52		1,250		—		1,061		—
Construction		—		—		—		—		—		—		—
Installment		27		27		—		10		—		9		—
Total	$	2,735	$	2,823	$	363	$	2,501	$	2	$	2,347	$	5

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Impaired loans by class at December 31, 2015 and for the three and six months ended June 30, 2015 are as follows:


	Period Ended						Three Months Ended				Six Months Ended
	December 31, 2015						June 30, 2015				June 30, 2015
			Unpaid				Average		Interest		Average		Interest
	Recorded		Principal		Related		Recorded		Income		Recorded		Income
(In thousands)	Investment		Balance		Allowance		Investment		Recognized		Investment		Recognized
With no related allowance recorded
Commercial, financial and agricultural	$	595	$	599	$	—	$	229	$	2	$	169	$	2
Residential:
First mortgage		264		322		—		159		1		153		2
Second mortgage		—		—		—		79		—		79		—
Commercial Real Estate:
Owner occupied		165		165		—		10		—		5		—
Non-owner occupied		482		482		—		—		—		—		—
Installment		22		22		—		—		—		—		—
With related allowance recorded
Commercial, financial and agricultural		—		—		—		331		—		248		—
Residential:
First mortgage		442		442		137		512		—		475		—
Second mortgage		—		—		—		11		—		9		—
Commercial Real Estate:
Owner occupied		—		—		—		—		—		—		—
Installment		—		—		—		—		—		—		—
Total
Commercial, financial and agricultural		595		599		—		560		2		417		2
Residential		706		764		137		761		1		716		2
Commercial Real Estate		647		647		—		10		—		5		—
Installment		22		22		—		—		—		—		—
Total	$	1,970	$	2,032	$	137	$	1,331	$	3	$	1,138	$	4

Residential and commercial loans serviced for others at June 30, 2016 and December 31, 2015 amounted to approximately $25.15 million and $27.87 million, respectively.

Nonperforming loans at June 30, 2016 and December 31, 2015 are as follows:


(In thousands)	June 30, 2016		December 31, 2015
Nonaccrual loans	$	3,659	$	3,513
Loans greater than 90 days and accruing		—		—
Troubled debt restructurings ("TDRs")		1,030		682
Total nonperforming loans	$	4,689	$	4,195

Of the total TDRs in the table above, $830 thousand at June 30, 2016 and $472 thousand at December 31, 2015, are non-accruing. There were no loans restructured in the three months ending June 30, 2016 and one loan restructured in the six months ending June 30, 2016 with a balance of $444 thousand. One TDR with a balance of $471 thousand was restructured in the three and six months ending June 30, 2015. The loan modified in 2016 was individually evaluated for impairment and it was determined that no reserve was required.

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TDRs represent balances where the existing loan was modified involving a concession in rate, term or payment amount due to the distressed financial condition of the borrower. There were three restructured residential mortgages at June 30, 2016 with balances totaling $117 thousand. There were two restructured commercial loans at June 30, 2016 with a balance of $469 thousand. There was one commercial real estate loan at June 30, 2016 with a balance of $444 thousand. Five of the six TDRs at June 30, 2016 continue to pay as agreed according to the modified terms. The one TDR that was delinquent at June 30, 2016 totaled $386 thousand. At June 30, 2016, there were no commitments to lend additional funds to borrowers whose loans have been modified in a troubled debt restructuring. We had no commitments to lend additional funds to borrowers whose loans were in nonaccrual status or to borrowers whose loans were 91 days past due and still accruing at June 30, 2016. Interest income on restructured loans during the three months ending June 30, 2016 and 2015 was insignificant.

Nonaccrual loans by class as of June 30, 2016 and December 31, 2015 are as follows:


(In thousands)	June 30, 2016		December 31, 2015
Commercial, financial and agricultural	$	757	$	823
Real estate - residential:
First mortgage		584		581
Second mortgage		—		—
Real estate - commercial:
Owner occupied		2,154		1,605
Non owner occupied		137		482
Installment		27		22
Total nonaccruing non-TDR loans	$	3,659	$	3,513
Nonaccruing TDR’s
Commercial, financial and agricultural		386		472
Real estate – residential:
First mortgage		—		—
Real estate - commercial:
Non owner occupied		444		—
Total nonaccrual loans including TDRs	$	4,489	$	3,985

Commercial Grading System

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

Pass rated loans exhibit acceptable risk to the bank in terms of financial capacity to repay their loans as well as possessing acceptable fallback repayment sources, typically collateral and personal guarantees. Pass rated commercial loan relationships with a total exposure of $1 million or greater are subject to a formal annual review process; additionally, management reviews the risk rating at the time of any late payments, overdrafts or other sign of deterioration in the interim.

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

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

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

Residential real estate and consumer loans

We do not use a grading system for our performing residential real estate and consumer loans. Credit quality for these loans is based on performance and payment status.

Below is a summary of loans by credit quality indicator as of June 30, 2016:


					Pass-		Special		Sub-
(In thousands)	Unrated		Pass		Watch		Mention		Standard		Total
Commercial, financial and agricultural	$	530	$	205,435	$	35,778	$	304	$	18,120	$	260,167
Municipal		37		51,809		8,629		115		—		60,590
Real estate – residential:
First mortgage		406,892		6,293		1,590		—		681		415,456
Second mortgage		40,449		—		227		—		—		40,676
Real estate – commercial:
Owner occupied		227		169,987		29,684		1,867		14,470		216,235
Non-owner occupied		470		293,266		45,271		451		4,363		343,821
Real estate – construction:
Residential		3		2,108		335		—		—		2,446
Commercial		255		42,342		4,018		—		1,727		48,342
Installment		7,602		—		—		—		27		7,629
All other loans		31		—		—		—		—		31
Total	$	456,496	$	771,240	$	125,532	$	2,737	$	39,388	$	1,395,393

Below is a summary of loans by credit quality indicator as of December 31, 2015:


					Pass-		Special		Sub-
(In thousands)	Unrated		Pass		Watch		Mention		Standard		Total
Commercial, financial and agricultural	$	597	$	179,451	$	45,977	$	4,177	$	7,249	$	237,451
Municipal		58		92,011		13,352		—		—		105,421
Real estate – residential:
First mortgage		420,798		4,733		164		—		581		426,276
Second mortgage		42,167		—		—		—		—		42,167
Real estate – commercial:
Owner occupied		296		161,810		41,477		5,959		11,466		221,008
Non-owner occupied		166		290,337		44,485		444		1,564		336,996
Real estate – construction:
Residential		478		1,944		—		—		—		2,422
Commercial		145		27,299		3,136		—		1,800		32,380
Installment		10,093		—		—		—		22		10,115
All other loans		44		—		—		—		—		44
Total	$	474,842	$	757,585	$	148,591	$	10,580	$	22,682	$	1,414,280

The carrying amount of loans purchased with evidence of credit deterioration accounted for under ASC 310-30 acquired in the acquisition totaled $2.65 million and $3.24 million at June 30, 2016 and December 31, 2015, respectively. There was no transfer of nonaccretable yield to accretable.

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NOTE 8: FAIR VALUE OF FINANCIAL INSTRUMENTS

We record certain assets and liabilities at fair value. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value measurements are also utilized to determine the initial value of certain assets and liabilities, to perform impairment assessments, and for disclosure purposes. We use quoted market prices and observable inputs to the maximum extent possible when measuring fair value. In the absence of quoted market prices, various valuation techniques are utilized to measure fair value. When possible, observable market data for identical or similar financial instruments are used in the valuation. When market data is not available, fair value is determined using valuation models that incorporate Management’s estimates of the assumptions a market participant would use in pricing the asset or liability.

The fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurement) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy are described below:

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

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

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

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

The types of instruments valued based on quoted market prices in active markets include most U.S. government and Agency securities, liquid mortgage products, active listed equities and most money market securities. Such instruments are generally classified within Level 1 or Level 2 of the fair value hierarchy. We do not adjust the quoted price for such instruments.

The types of instruments valued based on quoted prices in markets that are not active, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency include most investment-grade and high-yield corporate bonds, less liquid mortgage products, less liquid Agency securities, less liquid listed equities, state, municipal and provincial obligations, and certain physical commodities. Such instruments are generally classified within Level 2 of the fair value hierarchy.

Level 3 is for positions that are not traded in active markets or are subject to transfer restrictions; valuations are adjusted to reflect illiquidity and/or non-transferability, and such adjustments are generally based on available market evidence. In the absence of such evidence, Management’s best estimate will be used. Management’s best estimate consists of both internal and external support on certain Level 3 investments. Subsequent to inception, Management only changes Level 3 inputs and assumptions when corroborated by evidence such as transactions in similar instruments, completed or pending third-party transactions in the underlying investment or comparable entities, subsequent rounds of financing, recapitalizations and other transactions across the capital structure, offerings in the equity or debt markets, and changes in financial ratios or cash flows.

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Financial instruments on a recurring basis

The table below presents the balance of financial assets and liabilities at June 30, 2016 measured at fair value on a recurring basis:


			Fair Value Measurements at Reporting Date Using
			Quoted Prices in
			Active Markets for		Significant Other		Significant
			Identical Assets		Observable Inputs		Unobservable Inputs
(In thousands)	Total		(Level 1)		(Level 2)		(Level 3)
Assets
U.S. Treasury Obligations	$	25,425	$	—	$	25,425	$	—
U.S. GSEs		41,950		—		41,950		—
FHLB Obligations		41,092		—		41,092		—
Agency MBSs		88,171		—		88,171		—
Agency CMBSs		24,708		—		24,708		—
Agency CMOs		58,394		—		58,394		—
ABSs		338		—		338		—
Interest rate swap agreements		2,691		—		2,691		—
Total assets	$	282,769	$	—	$	282,769	$	—
Liabilities
Interest rate swap agreements		2,213		—		2,213		—
Total liabilities	$	2,213	$	—	$	2,213	$	—

The table below presents the balance of financial assets and liabilities at December 31, 2015 measured at fair value on a recurring basis:


			Fair Value Measurements at Reporting Date Using
			Quoted Prices in
			Active Markets for		Significant Other		Significant
			Identical Assets		Observable Inputs		Unobservable Inputs
(In thousands)	Total		(Level 1)		(Level 2)		(Level 3)
Assets
U.S. Treasury Obligations	$	25,113	$	—	$	25,113	$	—
U.S. GSEs		20,794		—		20,794		—
FHLB Obligations		51,111		—		51,111		—
Agency MBSs		97,249		—		97,249		—
Agency CMBSs		24,553		—		24,553		—
Agency CMOs		64,279		—		64,279		—
ABSs		355		—		355		—
Interest rate swap agreements		1,084		—		1,084		—
Total assets	$	284,538	$	—	$	284,538	$	—
Liabilities
Interest rate swap agreements		1,004		—		1,004		—
Total liabilities	$	1,004	$	—	$	1,004	$	—

Investment securities are reported at fair value utilizing Level 2 inputs. The prices for these instruments are obtained through an independent pricing service or dealer market participant with whom we have historically transacted both purchases and sales of investment securities. Prices obtained from these sources include market quotations and matrix pricing. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things. More information regarding our investment securities can be found in Note 5 to these consolidated financial statements.

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The interest rate swaps are reported at their fair value utilizing Level 2 inputs from third parties. The fair value of our interest rate swaps are determined using prices obtained from a third party advisor. The fair value measurement of the interest rate swap is determined by netting the discounted future fixed cash payments and the discounted expected variable cash receipts. The variable cash receipts are based on the expectation of future interest rates derived from observed market interest rate curves.

There were no transfers between Level 1 and Level 2 for the six months ended June 30, 2016 or June 30, 2015. There were no Level 3 assets measured at fair value on a recurring basis at June 30, 2016 or December 31, 2015.

Financial instruments on a non-recurring basis

Certain financial assets are also measured at fair value on a non-recurring basis, however they were not material at June 30, 2016 or December 31, 2015. These financial assets include impaired loans and Other Real Estate Owned (“OREO”).

Fair value of financial instruments

The fair value of Merchants’ financial instruments as of June 30, 2016 are summarized in the table below:


	Carrying
(In thousands)	Amount		Fair Value		Level 1		Level 2		Level 3
Cash and cash equivalents	$	59,522	$	59,522	$	59,522	$	—	$	—
Securities available for sale		280,078		280,078		—		280,078		—
Securities held to maturity		111,070		114,591		—		114,591		—
FHLB stock		7,036		N/A		N/A		N/A		N/A
Loans, net of allowance for loan losses		1,382,973		1,391,031		—		—		1,391,031
Interest rate swap agreement		2,691		2,691		—		2,691		—
Accrued interest receivable		3,714		3,714		—		1,052		2,662
Total	$	1,847,084	$	1,851,627	$	59,522	$	398,412	$	1,393,693
Deposits	$	1,453,330	$	1,453,919	$	1,234,083	$	219,836	$	—
Short-term borrowings		70,000		70,000		—		70,000		—
Securities sold under agreement to repurchase		184,920		184,882		—		184,882		—
Other long-term debt		3,694		3,733		—		3,733		—
Junior subordinated debentures issued to unconsolidated subsidiary trust		20,619		15,685		—		15,685		—
Interest rate swap agreement		2,213		2,213		—		2,213		—
Accrued interest payable		66		66		12		54		—
Total	$	1,734,842	$	1,730,498	$	1,234,095	$	496,403	$	—

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The fair value of Merchants’ financial instruments as of December 31, 2015 are summarized in the table below:


	Carrying
(In thousands)	Amount		Fair Value		Level 1		Level 2		Level 3
Cash and cash equivalents	$	150,183	$	150,183	$	150,183	$	—	$	—
Securities available for sale		283,454		283,454		—		283,454		—
Securities held to maturity		119,674		120,093		—		120,093		—
FHLB stock		3,797		N/A		N/A		N/A		N/A
Loans, net of allowance for loan losses		1,402,240		1,397,877		—		—		1,397,877
Interest rate swap agreement		1,084		1,084		—		1,084		—
Accrued interest receivable		4,374		4,374		—		1,085		3,289
Total	$	1,964,806	$	1,957,065	$	150,183	$	405,716	$	1,401,166
Deposits	$	1,551,439	$	1,551,046	$	1,296,867	$	254,179	$	—
Securities sold under agreement to repurchase		286,639		286,586		—		286,586		—
Other long-term debt		5,238		5,191		—		5,191		—
Junior subordinated debentures issued to unconsolidated subsidiary trust		20,619		14,975		—		14,975		—
Interest rate swap agreement		1,004		1,004		—		1,004		—
Accrued interest payable		152		152		13		139		—
Total	$	1,865,091	$	1,858,954	$	1,296,880	$	562,074	$	—

The carrying amounts reported in the consolidated balance sheets for cash and cash equivalents, accrued interest receivable and accrued interest payable approximate fair value. It is not practical to determine the fair value of FHLB stock due to restrictions placed on its transferability.

The methodologies for other financial assets and financial liabilities are discussed below.

Loans - The fair value for loans is estimated using discounted cash flow analyses, using interest rates and spreads currently being offered for loans with similar terms to borrowers of similar credit quality resulting in a Level 3 classification. Impaired loans are valued at the lower of cost or fair value as described previously. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price.

Deposits - The fair value of deposits with no stated maturity, which includes demand, savings, interest bearing checking and money market accounts, is equal to the amount payable on demand resulting in a Level 1 classification. The fair value of variable rate, fixed term certificates of deposit also approximates the carrying amount reported in the consolidated balance sheets. The fair value of fixed rate and fixed term certificates of deposit is estimated using a discounted cash flow method which applies interest rates currently being offered for deposits of similar remaining maturities resulting in a Level 2 classification.

Debt - The fair value of debt is estimated using current market rates for borrowings of similar remaining maturity resulting in a Level 2 classification.

Commitments to Extend Credit and Standby Letters of Credit - The fair value of commitments to extend credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of financial standby letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties. The fair value of commitments to extend credit and standby letters of credit is not material as of June 30, 2016 and December 31, 2015.

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NOTE 9: EMPLOYEE BENEFIT PLANS

Pension Plan

Prior to January 1995, we maintained a noncontributory defined benefit plan (the “Pension Plan”) covering all eligible employees. During 1995, the Pension Plan was curtailed. Accordingly, all accrued benefits were fully vested and no additional years of service or age will be accrued.

The following tables summarize the components of net periodic benefit cost and other changes in Pension Plan assets and benefit obligations recognized in other comprehensive income for the three and six months ended June 30, 2016 and 2015:


	Three Months Ended				Six Months Ended
	June 30,				June 30,
(In thousands)	2016		2015		2016		2015
Interest cost	$	112	$	112	$	224	$	224
Expected return on plan assets		(242)		(264)		(484)		(528)
Service costs		15		13		29		26
Net loss amortization		116		103		232		206
Net periodic pension cost (benefit)	$	1	$	(36)	$	1	$	(72)

We have no minimum required contribution for 2016.

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

NOTE 10: EARNINGS PER SHARE

The following table presents reconciliations of the calculations of basic and diluted earnings per share for the three and six months ended June 30, 2016 and 2015:


	Three Months Ended				Six Months Ended
	June 30,				June 30,
(In thousands except per share data)	2016		2015		2016		2015
Net income	$	4,366	$	3,116	$	7,856	$	6,452
Weighted average common shares outstanding		6,866		6,331		6,861		6,330
Dilutive effect of common stock equivalents		21		15		21		14
Weighted average common and common equivalent shares outstanding		6,887		6,346		6,882		6,344
Basic earnings per common share	$	0.64	$	0.49	$	1.15	$	1.02
Diluted earnings per common share	$	0.63	$	0.49	$	1.14	$	1.02

Basic earnings per common share were computed by dividing net income by the weighted average number of shares of common stock outstanding during the year. Diluted earnings per common share were computed by including potentially dilutive shares on the weighted average share count. Anti-dilutive warrants totaling 34,370 shares have been excluded from the calculation of diluted EPS for the three and six months ended June 30, 2016, respectively. There were no anti-dilutive shares excluded for the three or six months ended June 30, 2015.

NOTE 11: STOCK REPURCHASE PROGRAM

We extended our stock buyback program through January 26, 2017. Under the program, which was originally adopted in January 2007, we may repurchase up to 200,000 shares of our common stock on the open market from time to time, and have purchased 143,475 shares at an average price per share of $23.00 since the program's adoption. There were no shares repurchased during the three or six months ended June 30, 2016.

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NOTE 12: COMMITMENTS AND CONTINGENCIES

Financial Instruments with 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. We use the same credit policies in making commitments as we do for on-balance sheet instruments.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since a portion of the commitment is expected to expire without being drawn upon, the total commitment amount does not necessarily represent a future cash requirement. We evaluate each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained by us upon extension of credit is based on Management's credit evaluation of the counterparty, and an appropriate amount of real and/or personal property is typically obtained as collateral.

Disclosures are required regarding liability-recognition for the fair value at issuance of certain guarantees. We do not issue any guarantees that would require liability-recognition or disclosure, other than our standby letters of credit. We have 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 $6.23 million at June 30, 2016 and $6.30 million at December 31, 2015, respectively, and represent the maximum potential future payments we could be required to make. Typically, these instruments have terms of 12 months or less and expire unused; therefore, the total amounts do not necessarily represent future cash requirements. Each customer is evaluated individually for creditworthiness under the same underwriting standards used for commitments to extend credit and on-balance sheet instruments. Our policies governing loan collateral apply to standby letters of credit at the time of credit extension. Loan-to-value ratios are generally consistent with loan-to-value requirements for other commercial loans secured by similar types of collateral.

We may enter into commitments to sell loans, which involve market and interest rate risk. There were no such commitments at June 30, 2016 or December 31, 2015.

Balances at the Federal Reserve Bank

At June 30, 2016 and December 31, 2015, amounts at the Federal Reserve Bank included $29.32 million and $30.52 million, respectively, held to satisfy certain reserve requirements of the Federal Reserve Bank.

Legal Proceedings

We have been named as defendants in various legal proceedings arising from our 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 input from counsel on the anticipated outcome of such proceedings, any such liability will not have a material effect on our consolidated financial position.

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NOTE 13: ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)

The following table presents changes in accumulated other comprehensive income (loss) by component, net of tax for the three and six months ended June 30, 2016.


	Unrealized		Unrealized Gains
	Gains (Losses)		(Losses) on Securities
	on Securities		Transferred From						Accumulated Other
	Available-For-		Available-For-Sale to				Interest Rate		Comprehensive
(In thousands)	Sale		Held-To-Maturity		Pension Plan		Swaps		Income (Loss)
Beginning Balance March 31, 2016	$	2,790	$	(2,170)	$	(3,662)	$	(120)	$	(3,162)
Other comprehensive income before reclassifications		883		—		—		41		924
Accretion of unrealized losses of securities transferred from available-for-sale to held-to-maturity recognized in other comprehensive income		—		121		—		—		121
Reclassification adjustments for (gains) losses reclassified into income		—		—		75		—		75
Net current period other comprehensive (loss) income		883		121		75		41		1,120
Balance June 30, 2016	$	3,673	$	(2,049)	$	(3,587)	$	(79)	$	(2,042)

Beginning Balance December 31, 2015	$	166	$	(2,297)	$	(3,737)	$	(155)	$	(6,023)
Other comprehensive income before reclassifications		3,507		—		—		76		3,583
Accretion of unrealized losses of securities transferred from available-for-sale to held-to-maturity recognized in other comprehensive income		—		248		—		—		248
Reclassification adjustments for (gains) losses reclassified into income		—		—		150		—		150
Net current period other comprehensive (loss) income		3,507		248		150		76		3,981
Balance June 30, 2016	$	3,673	$	(2,049)	$	(3,587)	$	(79)	$	(2,042)

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The following table presents changes in accumulated other comprehensive income (loss) by component, net of tax for the three and six months ended June 30, 2015.


	Unrealized		Unrealized Gains
	Gains (Losses)		(Losses) on Securities
	on Securities		Transferred From						Accumulated Other
	Available-For-		Available-For-Sale to				Interest Rate		Comprehensive
(In thousands)	Sale		Held-To-Maturity		Pension Plan		Swaps		Income (Loss)
Beginning Balance March 31, 2015	$	2,265	$	(2,700)	$	(3,328)	$	(290)	$	(4,053)
Other comprehensive income before reclassifications		(1,065)		—		—		—		(1,065)
Accretion of unrealized losses of securities transferred from available-for-sale to held-to-maturity recognized in other comprehensive income		—		128		—		—		128
Reclassification adjustments for (gains) losses reclassified into income		—		—		67		—		67
Net current period other comprehensive (loss) income		(1,065)		128		67		—		(870)
Balance June 30, 2015	$	1,200	$	(2,572)	$	(3,261)	$	(290)	$	(4,923)

Beginning Balance December 31, 2014	$	1,482	$	(2,824)	$	(3,395)	$	(311)	$	(5,048)
Other comprehensive income before reclassifications		(282)		—		—		21		(261)
Accretion of unrealized losses of securities transferred from available-for-sale to held-to-maturity recognized in other comprehensive income		—		252		—		—		252
Reclassification adjustments for (gains) losses reclassified into income		—		—		134		—		134
Net current period other comprehensive (loss) income		(282)		252		134		21		125
Balance June 30, 2015	$	1,200	$	(2,572)	$	(3,261)	$	(290)	$	(4,923)

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Details of the reclassification adjustments in the above table for the three and six months ended June 30, 2016 and 2015 are presented below:



Details about Accumulated Other	Three Months Ended		Six Months Ended
Comprehensive Income Components	June 30,		June 30,		Affected Line Item in the Statement
(In thousands)	2016		2016		Where Net Income is Presented
Amortization of defined benefit pension plan
	$	(116)	$	(232)	Compensation and benefits expense
		(116)		(232)	Total before tax
		41		82	Provision for income taxes
	$	(75)	$	(150)	Net of tax

Total reclassification adjustments	$	(75)	$	(150)	(Increase) / Decrease to net income



Details about Accumulated Other	Three Months Ended		Six Months Ended
Comprehensive Income Components	June 30,		June 30,		Affected Line Item in the Statement
(In thousands)	2015		2015		Where Net Income is Presented
Amortization of defined benefit pension plan
	$	103	$	206	Compensation and benefits expense
		103		206	Total before tax
		(36)		(72)	Provision for income taxes
	$	67	$	134	(Increase) / Decrease to net income

Total reclassification adjustments	$	67	$	134	(Increase) / Decrease to net income

NOTE 14: DERIVATIVE FINANCIAL INSTRUMENTS

At June 30, 2016 and December 31, 2015, we had an interest rate swap with a notional amount of $10 million that was designated as a cash flow hedge. The swap was used to convert a portion of the floating rate interest on our trust preferred issuance to a fixed rate of interest. Each quarter we assess the effectiveness of the hedging relationships by comparing the changes in cash flows of the derivative hedging instruments with the changes in cash flows of the designated hedged item. There was no ineffective portion recognized in earnings during the three or six months ended June 30, 2016 or June 30, 2015. The fair value of $122 thousand and $239 thousand was reflected in other liabilities in the accompanying consolidated balance sheets at June 30, 2016 and December 31, 2015, respectively.

We entered into interest rate swaps with a notional amount of $45.8 million with certain commercial customers. In order to minimize our risk, these customer derivatives (pay floating/receive fixed swaps) have been offset with essentially matching interest rate swaps with our counterparty totaling $45.8 million (pay fixed/receive floating swaps). At June 30, 2016, the weighted average receive rate of these interest rate swaps was 2.18%, the weighted average pay rate was 3.64% and the weighted average maturity was 9.6 years. The fair values of $2.091 million and $2.091 million were reflected in other assets and other liabilities, respectively, in the accompanying consolidated balance sheets at June 30, 2016. At December 31, 2015, the weighted average receive rate of these interest rate swaps was 2.13%, the weighted average pay rate was 3.60% and the weighted average maturity was 10.2 years. The fair values of $765 thousand and $765 thousand were reflected in other assets and other liabilities, respectively, in the accompanying consolidated balance sheets at December 31, 2015. Hedge accounting has not been applied for these derivatives. Because the terms of the swaps with our customer and the other financial institution offset each other, with the only difference being counterparty credit risk, changes in the fair value of the underlying derivative contracts are not materially different and do not significantly impact our results of operations.

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We entered into interest rate swaps with notional amounts totaling $8.5 million at June 30, 2016, and $9.8 million at December 31, 2015, that were designated as fair value hedges of certain fixed rate loans with municipalities. At June 30, 2016, the weighted average receive rate of these interest rate swaps was 1.82%, the weighted average pay rate was 3.27% and the weighted average maturity was 16.0 years. The fair value of $600 thousand at June 30, 2016, was reflected as a reduction to loans and an increase to other assets. At December 31, 2015 the weighted average receive rate of these interest rate swaps was 1.78%, the weighted average pay rate was 3.25% and the weighted average maturity was 16.6 years. The fair value of $319 thousand at December 31, 2015, was reflected as a reduction to loans and an increase to other assets. The ineffective portion of the interest swaps was immaterial and as such, amounts are not recognized in earnings.

We assessed our counterparty risk at June 30, 2016 and determined any credit risk inherent in our derivative contracts was insignificant. Information about the fair value of derivative financial instruments can be found in Note 8 to these consolidated financial statements.

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Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Statements

Certain statements contained in this Quarterly Report on Form 10-Q that are not historical facts may constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and are intended to be covered by the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements involve risks and uncertainties. These statements, which are based on certain assumptions and describe our future plans, strategies and expectations, can generally be identified by the use of the words “may,” “will,” “should,” “could,” “would,” “plan,” “potential,” “estimate,” “project,” “believe,” “intend,” “anticipate,” “expect,” “target” and similar expressions. These statements include, among others, statements regarding our intent, belief or expectations with respect to economic conditions, trends affecting our financial condition or results of operations, and our exposure to market, interest rate and credit risk.

Forward-looking statements are based on the current assumptions and beliefs of Management and are only expectations of future results. Our actual results could differ materially from those projected in the forward-looking statements as a result of, among other factors, difficulties in achieving cost savings in connection with the recent acquisition of NUVO Bank & Trust Company (“NUVO”) or in achieving such cost savings within the expected timeframe; adverse conditions in the capital and debt markets; changes in interest rates; competitive pressures from other financial institutions and non-bank entities; weakness in general economic conditions on a national basis or in the local markets in which we operate, including changes which adversely affect borrowers’ ability to service and repay our loans; changes in the value of securities and other assets; changes in loan default and charge-off rates; the adequacy of loan loss reserves; reductions in deposit levels necessitating increased borrowing to fund loans and investments; changes in government regulation; and changes in assumptions used in making such forward-looking statements, as well as the other risks and uncertainties detailed in our Annual Report on Form 10-K. Forward-looking statements speak only as of the date on which they are made. We do not undertake any obligation to update any forward-looking statement to reflect circumstances or events that occur after the date the forward-looking statement is made.

Use of Non-GAAP Financial Measures

Certain information in Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contains financial information determined by methods other than in accordance with accounting principles generally accepted in the United States of America (“GAAP”). We use these “non-GAAP” measures in our analysis of our performance and believe that these non-GAAP financial measures provide a greater understanding of ongoing operations and enhance comparability of results with prior periods as well as demonstrating the effects of significant gains and charges in the current period. We believe that a meaningful analysis of our financial performance requires an understanding of the factors underlying that performance. We believe that investors may use these non-GAAP financial measures to analyze financial performance without the impact of unusual items that may obscure trends in our underlying performance. These disclosures should not be viewed as a substitute for operating results determined in accordance with GAAP, nor are they necessarily comparable to non-GAAP performance measures that may be presented by other companies.

In several places net interest income is presented on a fully taxable equivalent basis. Specifically included in interest income is tax-exempt interest income from certain tax-exempt loans. An amount equal to the tax benefit derived from this tax exempt income is added back to the interest income total, to produce net interest income on a fully taxable equivalent basis. We believe the disclosure of taxable equivalent net interest income information improves the clarity of financial analysis, and is particularly useful to investors in understanding and evaluating the changes and trends in our results of operations. Other financial institutions commonly present net interest income on a taxable equivalent basis. This adjustment is considered helpful in the comparison of one financial institution’s net interest income to that of another, as each will have a different proportion of taxable exempt interest from its earning assets. Moreover, net interest income is a component of a second financial measure commonly used by financial institutions, net interest margin, which is the ratio of net interest income to average earning assets. A reconciliation of taxable equivalent financial information to our consolidated financial statements prepared in accordance with GAAP appears at the bottom of the table entitled “Distribution of Assets, Liabilities and Stockholders’ Equity; Interest Rates and Net Interest Margin” on page 37.

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Additionally, in several places adjusted financial measures are presented. Adjusted noninterest expense excludes non-recurring expenses not considered integral to the Company’s normal operations. Specifically excluded in adjusted noninterest expense are merger and severance costs. Adjusted net income is GAAP net income adjusted for these non-recurring elements of noninterest expense. These adjustments are considered helpful in the comparison of quarterly noninterest expense and net income. Reconciliations of adjusted net income and adjusted noninterest expense to our consolidated financial statements prepared in accordance with GAAP appear on pages 36 and 40 and are titled “Adjusted Net Income non-GAAP Reconciliation” and “Adjusted Noninterest Expense Non-GAAP Reconciliation,” respectively.

A 35.0% tax rate was used in both 2016 and 2015.

General

The following discussion and analysis of financial condition as of June 30, 2016 and December 31, 2015 and results of operations of Merchants and its subsidiaries for the three and six months ended June 30, 2016 and 2015 should be read in conjunction with the consolidated financial statements and notes thereto and selected statistical information appearing elsewhere in this Quarterly Report on Form 10-Q. The financial condition and results of operations of Merchants essentially reflect the operations of its principal subsidiary, Merchants Bank.

RESULTS OF OPERATIONS

Overview

We realized net income of $4.37 million, or $0.63 per diluted share, for the second quarter of 2016 compared to net income $3.12 million in net income, or $0.49 per diluted share, in the second quarter of 2015. Excluding acquisition and severance related expenses, net of tax, resulting from the Company’s acquisition of NUVO, the Company’s adjusted net income was $4.23 million or $0.61 per diluted share, compared to adjusted net income of $3.11 million and $0.49 per diluted share for the second quarter of 2015.

For the six months ended June 30, 2016, net income was $7.86 million, or $1.14 per diluted share, compared to net income of $6.45 million, or $1.02 per diluted share, for the same period in 2015. Excluding acquisition and severance related expenses, net of tax, adjusted net income would have been $8.05 million, or $1.16 per diluted share, for the six months ended June 30, 2016 compared to adjusted net income of $6.62 million and $1.04 per diluted share for the same period in 2015.

The return on average assets was 0.90% and 0.80% for the three and six months ended June 30, 2016, respectively, compared to 0.72% and 0.75% for the same periods in 2015. The return on average stockholders’ equity was 11.36% and 10.35% for the three and six months ended June 30, 2016, respectively, compared to 9.73% and 10.15% for the same periods in 2015.

Stockholders equity ended the quarter at $156.29 million. The book value per share at June 30, 2016 was $22.74 per share, an increase of $1.15 per share from $21.59 at December 31, 2015. The tangible book value per share at June 30, 2016 was $21.56 per share, an increase of $1.18 per share from $20.38 at December 31, 2015. At June 30, 2016, our Common Equity Tier 1 ratio was 13.02%. At June 30, 2016, the Tier 1 leverage ratio remained flat at 8.77%, the total risk-based capital ratio increased to 15.91% from 15.77% and the tangible capital ratio increased to 7.84% from 6.94%, at December 31, 2015. See page 36 for our tangible book value calculation.

Net interest income: Net interest income on a fully-taxable basis was $14.37 million and $28.64 million for the three and six months ended June 30, 2016, respectively, compared to $12.25 million and $24.31 million for the same periods in 2015.

Provision for Credit Losses: The Company recorded a $200 thousand and $405 thousand provision for credit losses for the three and six months ended June 30, 2016, compared to a $100 thousand provision for credit losses for both the three and six months ended June 30, 2015.

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Noninterest income: Noninterest income for the three and six months ended June 30, 2016 was $3.22 million and $6.15 million, respectively, an increase of $468 thousand and $722 thousand for the same periods in 2015.

Noninterest expense: Noninterest expense was $10.83 million and $22.75 million three and six months ended June 30, 2016, an increase of $352 thousand and $2.26 million from the same periods in 2015. Excluding merger and severance costs, adjusted noninterest expense was $11.02 million and $22.51 million for the three and six months ended June 30, 2016, respectively, compared to $10.48 million and $20.28 million for the same periods in 2015.

Loans: Loans were $1.40 billion for the second quarter of 2016, a decrease of $18.89 million from December 31, 2015. Average loans totaled $1.43 billion and $1.42 billion for the three and six months ended June 30, 2016, respectively compared to average loans of $1.22 billion and $1.20 billion for the three and six months ended June 30, 2015, respectively.

Investments: The investment portfolio, which includes FHLB stock, ended the quarter at $398.18 million, a decrease of $8.74 million from December 31, 2015.

Deposits: Total deposits were $1.45 billion for the second quarter of 2016, a decrease of $98.11 million from December 31, 2015. Average deposits totaled $1.50 billion and $1.51 billion for the three and six months ended June 30, 2016, respectively compared to average deposits of $1.35 billion and $1.34 billion for the three and six months ended June 30, 2015, respectively.

Adjusted Net Income Non-GAAP Reconciliation


	Three Months Ended				Six Months Ended
	June 30,				June 30,
(In thousands)	2016		2015		2016		2015
Merger related expenses and severance costs	$	(184)	$	(2)	$	238	$	213
Tax effect		(51)		—		46		44
Merger related expenses and severance costs, net of tax	$	(133)	$	(2)	$	192	$	169

GAAP net income as reported		4,366		3,116		7,856		6,452
Adjusted net income	$	4,233	$	3,114	$	8,048	$	6,621

Tangible Book Value Non-GAAP Reconciliation


	Period Ended
	June 30,		December 31,
(In thousands except share and per share data)	2016		2015
Total stockholders' equity	$	156,293	$	148,054
Core deposit intangible		1,258		1,360
Goodwill		6,872		6,967
Tangible stockholders' equity	$	148,163	$	139,727

Period end shares outstanding		6,871,642		6,855,294

Tangible book value per share	$	21.56	$	20.38

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Net Interest Income

As shown on the following tables, our fully taxable equivalent (“FTE”) net interest income was $14.37 million and $28.64 million for the three and six months ended June 30, 2016, respectively compared to $12.25 million and $24.31 million for the three and six months ended June 30, 2015, respectively. Our fully taxable equivalent net interest margin increased 13 and 11 basis points to 3.08% and 3.06% for the three and six months ended June 30, 2016, respectively from 2.95% and 2.95% for the same periods in 2015. The improvements from 2015 were driven by higher loan yields and a decrease in the cost of borrowings.

The following tables present an analysis of net interest income and interest income earned and interest expense charged for each major component of interest earning assets and interest bearing liabilities. Yields/rates are computed on a FTE basis, using a 35% rate. Nonaccrual loans are included in the average loan balance outstanding.

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


	Three Months Ended
	June 30, 2016						June 30, 2015
			Interest						Interest
	Average		Income/		Average		Average		Income/		Average
(In thousands, fully taxable equivalent)	Balance		Expense		Rate		Balance		Expense		Rate
ASSETS:
Loans, including fees on loans	$	1,426,966	$	13,437	3.79	%	$	1,220,418	$	11,305	3.72	%
Investments		405,418		1,988	1.97	%		379,376		1,913	2.02	%
Interest-earning deposits with banks and other short-term investments		37,018		58	0.63	%		66,247		59	0.36	%
Total interest earning assets		1,869,402		15,483	3.33	%		1,666,041		13,277	3.20	%
Allowance for loan losses		(12,249)						(12,075)
Cash and due from banks		26,684						23,663
Bank premises and equipment, net		14,350						15,561
Bank owned life insurance		10,626						10,395
Other assets		38,137						27,478
Total assets	$	1,946,950					$	1,731,063

LIABILITIES AND STOCKHOLDERS' EQUITY:
Interest-bearing deposits:
Savings, interest bearing checking and money market accounts	$	665,271	$	424	0.26	%	$	576,038	$	354	0.25	%
Time deposits		222,782		340	0.61	%		202,050		323	0.64	%
Total interest bearing deposits		888,053		764	0.35	%		778,088		677	0.35	%
Short-term borrowings		24,906		31	0.49	%		6,099		5	0.34	%
Securities sold under agreements to repurchase, short-term		235,927		103	0.18	%		213,436		146	0.27	%
Other long-term debt		4,196		16	1.54	%		2,285		12	2.04	%
Junior subordinated debentures issued to unconsolidated subsidiary trust		20,619		198	3.85	%		20,619		187	3.70	%
Total borrowed funds		285,648		348	0.49	%		242,439		350	0.58	%
Total interest bearing liabilities	$	1,173,701	$	1,112	0.38	%	$	1,020,527	$	1,027	0.40	%
Noninterest bearing deposits		609,454						574,660
Other liabilities		10,022						7,833
Stockholders' equity		153,773						128,043
Total liabilities and stockholders' equity	$	1,946,950					$	1,731,063

Net interest earning assets	$	695,701					$	645,514

Net interest income (fully taxable equivalent)			$	14,371					$	12,250
Tax equivalent adjustment				(540)						(504)
Net interest income			$	13,831					$	11,746

Net interest rate spread					2.95	%					2.80	%

Net interest margin					3.08	%					2.95	%

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	Six Months Ended
	June 30, 2016						June 30, 2015
	Interest						Interest
	Average		Income/		Average		Average		Income/		Average
(In thousands, fully taxable equivalent)	Balance		Expense		Rate		Balance		Expense		Rate
ASSETS:
Loans, including fees on loans	$	1,422,338	$	26,774	3.79	%	$	1,203,940	$	22,431	3.76	%
Investments		402,960		3,985	1.98	%		372,754		3,823	2.07	%
Interest-earning deposits with banks and other short-term investments		55,656		139	0.50	%		84,471		132	0.32	%
Total interest earning assets		1,880,954		30,898	3.30	%		1,661,165		26,386	3.20	%
Allowance for loan losses		(12,161)						(11,984)
Cash and due from banks		28,871						24,316
Bank premises and equipment, net		14,595						15,474
Bank owned life insurance		10,599						10,365
Other assets		37,353						25,385
Total assets	$	1,960,211					$	1,724,721

LIABILITIES AND STOCKHOLDERS' EQUITY:
Interest-bearing deposits:
Savings, interest bearing checking and money market accounts	$	668,547	$	864	0.26	%	$	558,539	$	721	0.26	%
Time deposits		231,300		731	0.64	%		204,934		657	0.65	%
Total interest bearing deposits		899,847		1,595	0.36	%		763,473		1,378	0.36	%
Short-term borrowings		12,454		31	0.49	%		3,066		5	0.34	%
Securities sold under agreements to repurchase, short-term		247,963		212	0.17	%		221,728		301	0.27	%
Other long-term debt		4,515		32	1.39	%		2,297		23	2.03	%
Junior subordinated debentures issued to unconsolidated subsidiary trust		20,619		392	3.83	%		20,619		373	3.64	%
Total borrowed funds		285,551		667	0.47	%		247,710		702	0.57	%
Total interest bearing liabilities	$	1,185,398	$	2,262	0.38	%	$	1,011,183	$	2,080	0.41	%
Noninterest bearing deposits		613,004						578,594
Other liabilities		9,996						7,771
Stockholders' equity		151,813						127,173
Total liabilities and stockholders' equity	$	1,960,211					$	1,724,721

Net interest earning assets	$	695,556					$	649,982

Net interest income (fully taxable equivalent)			$	28,636					$	24,306
Tax equivalent adjustment				(1,073)						(1,008)
Net interest income			$	27,563					$	23,298

Net interest rate spread					2.92	%					2.79	%

Net interest margin					3.06	%					2.95	%

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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).

Analysis of Changes in Fully Taxable Equivalent Net Interest Income


	Three Months Ended						Due to
	June 30,				Increase						Volume/
(In thousands)	2016		2015		(Decrease)		Volume		Rate		Rate
Fully taxable equivalent interest income:
Loans, including fees on loans	$	13,437	$	11,305	$	2,132	$	1,910	$	204	$	18
Investments		1,988		1,913		75		131		(45)		(11)
Federal funds sold, securities sold under agreements to repurchase and interest bearing deposits with banks		58		59		(1)		(26)		44		(19)
Total interest income		15,483		13,277		2,206		2,015		203		(12)
Less interest expense:
Savings, interest bearing checking and money market accounts		424		354		70		55		9		6
Time deposits		340		323		17		33		(13)		(3)
Federal funds purchased and Federal Home Loan Bank short-term borrowings		31		5		26		16		2		8
Securities sold under agreements to repurchase, short-term		103		146		(43)		15		(50)		(8)
Other long-term debt		16		12		4		10		(3)		(3)
Junior subordinated debentures issued to unconsolidated subsidiary trust		198		187		11		—		8		3
Total interest expense		1,112		1,027		85		129		(47)		3
Net interest income	$	14,371	$	12,250	$	2,121	$	1,886	$	250	$	(15)


	Six Months Ended						Due to
	June 30,				Increase						Volume/
(In thousands)	2016		2015		(Decrease)		Volume		Rate		Rate
Fully taxable equivalent interest income:
Loans, including fees on loans	$	26,774	$	22,431	$	4,343	$	2,042	$	76	$	2,225
Investments		3,985		3,823		162		155		(85)		92
Federal funds sold, securities sold under agreements to repurchase and interest bearing deposits with banks		139		132		7		(23)		38		(8)
Total interest income		30,898		26,386		4,512		2,174		29		2,309
Less interest expense:
Savings, interest bearing checking and money market accounts		864		721		143		71		—		72
Time deposits		731		657		74		43		(7)		38
Federal funds purchased and Federal Home Loan Bank short-term borrowings		31		5		26		8		1		17
Securities sold under agreements to repurchase, short-term		212		301		(89)		18		(54)		(53)
Other long-term debt		32		23		9		11		(4)		2
Junior subordinated debentures issued to unconsolidated subsidiary trust		392		373		19		—		10		9
Total interest expense		2,262		2,080		182		151		(54)		85
Net interest income	$	28,636	$	24,306	$	4,330	$	2,023	$	83	$	2,224

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Provision for Credit Losses

The allowance for loan losses at June 30, 2016 was $12.42 million, or 0.89% of total loans and 265% of nonperforming loans, compared to $12.04 million, or 0.85% of total loans and 287% of nonperforming loans at December 31, 2015, respectively. We recorded a $200 thousand and $405 thousand provision for credit losses for the three and six months ended June 30, 2016, compared to a $100 thousand provision for credit losses for both the three and six months ended June 30, 2015. The primary factors for the provision in the second quarter of 2016 were to support growth in loan balances, an increase in specific reserves allocated to impaired loans, and an in increase in the level of classified loans. Performing loans past due 31-90 days were 0.06% of total loans at June 30, 2016 compared to 0.05% at December 31, 2015. Nonperforming loans as a percent of total loans were 0.34% at June 30, 2016 compared to 0.30% at December 31, 2015. Accruing substandard loans increased to 2.50% of total loans at June 30, 2016 compared to 1.32% at December 31, 2015. Net charge-offs for the six months ending June 30, 2016 totaled $89 thousand. All of these factors are taken into consideration during Management’s quarterly review of the Allowance. For a more detailed discussion of our Allowance and nonperforming assets, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Credit Quality and Allowance for Credit Losses” below.

NONINTEREST INCOME AND EXPENSES

Noninterest Income

Noninterest income for the three and six months ended June 30, 2016 was $3.22 million and $6.15 million, respectively, an increase of $468 thousand and $722 thousand for the same periods in 2015. The improvement from the second quarter of 2015 was driven by increases in overdraft income, deposit fees and other fee income.

Noninterest Expense

Noninterest expense was $10.83 million and $22.75 million three and six months ended June 30, 2016, an increase of $352 thousand and $2.26 million from the same periods in 2015. Excluding merger and severance costs, adjusted noninterest expense was $11.02 million and $22.51 million for the three and six months ended June 30, 2016, respectively, compared to $10.48 million and $20.28 million for the same periods in 2015. The increase of $534 thousand on a quarter to quarter basis is primarily attributable to a full quarter of NUVO operations. The increase of $2.24 million on a year to date basis is largely due to the following items:

In both the first and second quarters of 2016 we recognized the impact of noninterest expenses related to NUVO. The related expenses during the six month period were $1.56 million.

Total compensation and benefits increased by $566 thousand during the six months ended June 30, 2016 which is primarily attributable to higher commission and incentive expense and employee benefit expense.

Professional fees increased by $350 thousand during the current period which is primarily driven by temporary contracted consulting services related to interim senior management positions.

Adjusted Noninterest Expense Non-GAAP Reconciliation


	Three Months Ended				Six Months Ended
	June 30,				June 30,
(In thousands)	2016		2015		2016		2015
Noninterest expense	$	10,833	$	10,481	$	22,752	$	20,488
Less:
Merger related expenses		(72)		143		61		148
Severance costs		(112)		(145)		177		65
Adjusted noninterest expense	$	11,017	$	10,483	$	22,514	$	20,275

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Income Taxes

Merchants Bancshares’ effective tax rate was 27.5% and 25.5% for the three and six months ended June 30, 2016, respectively, compared to 23.0% on a linked quarter basis and 20.4% and 20.7% for the three and six months ended June 30, 2015. The increase is mainly due to changes in business loan composition and partially reflects reduced Low Income Housing Partnership tax credits.

BALANCE SHEET ANALYSIS

Our total assets were $1.90 billion at June 30, 2016, a decrease of $122.53 million from December 31, 2015. Average earning assets increased to $1.87 billion and $1.88 billion for the three and six months ended June 30, 2016, respectively, from $1.67 and $1.66 billion for the three and six months ended June 30, 2015, respectively, mainly due to the NUVO acquisition.

Loans

Average loans for the three months ending June 30, 2016 were $1.43 billion, a $9.26 million, or 0.65%, increase over average loans on a linked quarter basis and an increase of $206.55 million, or 16.92% over the same period in 2015. Loans at June 30, 2016 were $1.40 billion, an $18.89 million decrease from $1.41 billion at December 31, 2015. The decline in loan balances is mainly driven by seasonal run-off of the municipal loans, which is partially offset by the growth in total commercial loans.

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


(In thousands)	June 30, 2016		March 31, 2016		December 31, 2015		June 30, 2015
Commercial, financial and agricultural	$	260,167	$	247,074	$	237,451	$	210,458
Municipal loans		60,590		105,433		105,421		59,035
Residential		456,132		461,009		468,443		454,114
Commercial Real Estate		560,056		556,836		558,004		438,622
Construction		50,788		42,209		34,802		38,435
Installment loans		7,629		9,009		10,115		2,950
All other loans		31		33		44		41
Total loans	$	1,395,393	$	1,421,603	$	1,414,280	$	1,203,655

Totals above are shown net of deferred loans fees of $1.14 million, $1.22 million, $1.20 million, and $748 thousand for June 30, 2016, March 31, 2016, December 31, 2015, and June 30, 2015, respectively.

Investments

The investment portfolio is used to generate interest income, and to manage liquidity and interest rate sensitivity. The average investment portfolio, including FHLB stock, for the second quarter of 2016 was $405.42 million, an increase of $26.04 million from the average balance for the second quarter of 2015. The ending balance in the investment portfolio, including FHLB stock, at June 30, 2016 was $398.18 million, compared to $406.93 million at December 31, 2015. The book balance of the portfolio at June 30, 2016 includes a $5.66 million unrealized gain on the available for sale portion of the investment portfolio, compared to an unrealized gain of $269 thousand at June 30, 2015 and December 31, 2015.

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The composition of our investment portfolio as of June 30, 2016, including both available for sale and held to maturity securities, consisted of the following:


	Amortized		Fair
(In thousands)	Cost		Value
Available for Sale:
U.S. Treasury Obligations	$	25,072	$	25,425
U.S. Government Sponsored Enterprises ("U.S. GSEs")		41,246		41,950
Federal Home Loan Bank ("FHLB") Obligations		40,078		41,092
Residential Real Estate Mortgage-backed Securities ("Agency MBSs")		85,668		88,171
Agency Commercial Mortgage Backed Securities ("Agency CMBSs")		24,342		24,708
Agency Collateralized Mortgage Obligations ("Agency CMOs")		57,707		58,394
Asset Backed Securities ("ABSs")		301		338
Total Available for Sale	$	274,414	$	280,078
Held to Maturity:
U.S. Agency Obligations	$	18,964	$	19,935
U.S. GSEs		9,585		10,001
FHLB Obligations		4,777		5,001
Agency CMOs		71,228		72,820
Agency MBSs		6,516		6,834
Total Held to Maturity		111,070		114,591
Total Securities	$	385,484	$	394,669

Agency MBSs and Agency CMOs consist of pools of residential mortgages which are guaranteed by the FNMA, FHLMC, or GNMA with various origination dates and maturities. Agency CMBS consists of bonds backed by commercial real estate which are guaranteed by FNMA and GNMA.

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

As a member of the Federal Home Loan Bank (“FHLB”) of Boston, we are required to invest in stock of the FHLB in an amount determined based on our borrowings from the FHLB. Our investment in FHLB stock totaled $7.04 million at June 30, 2016 compared to $3.80 million at December 31, 2015. The FHLB continues to be classified as “adequately capitalized” by its primary regulator. Based on current available information, we have concluded that our investment in FHLB stock is not impaired. We will continue to monitor our investment in FHLB stock.

Deposits and Other Liabilities

Our total deposit balances were $1.45 billion at June 30, 2016, a decrease of $98.11 million from December 31, 2015. Our average deposit balances increased to $1.50 billion for the three months ended June 30, 2016 from $1.35 billion from the same period in 2015. Average deposit balances increased to $1.51 billion for the six months ended June 30, 2016 from $1.34 billion from the same period in 2015. Securities sold under agreement to repurchase, which represent collateralized customer accounts, were $184.92 million at June 30, 2016, a reduction of $101.72 million from $286.64 million at December 31, 2015. The reduction from the prior year-end was due to the municipality seasonality that also impacted our loan balances.

Average securities sold under agreement to repurchase balances increased to $235.93 million for the three months ended June 30, 2016 from $213.44 million from the same period in 2015. Average securities sold under agreement to repurchase balances increased to $247.96 million for the six months ended June 30, 2016 from $221.73 million from the same period in 2015.

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CREDIT QUALITY AND ALLOWANCE FOR CREDIT LOSSES

Recent statistics on the United States economy show continued improvement in the labor market and a Real GDP increase at an annual rate of 1.1% in the first quarter of 2016. Nationwide unemployment rates have declined slightly to 4.9% at June 30, 2016 from 5.0% at December 31, 2015.

In Vermont, seasonally-adjusted statewide unemployment rates continue to decline and are tied for the 5th lowest unemployment rate in the country in April 2016. The Massachusetts seasonally-adjusted statewide unemployment rate was slightly lower than the national average and is ranked as the 16th lowest unemployment rate in the country.

Credit quality

Credit quality is a major strategic focus and strength of our company. Although we actively manage current nonperforming and classified loans, there is no assurance that we will not have increased levels of problem assets in the future. The composition of the nonperforming pool is dynamic with accounts moving in and out of this category over time.

The following table summarizes our nonperforming loans (“NPL”) and nonperforming assets (“NPA”) as of the dates indicated:


(In thousands)	June 30, 2016		March 31, 2016		December 31, 2015		June 30, 2015
Nonaccrual loans	$	3,659	$	3,777	$	3,513	$	748
Loans past due greater than 90 days and accruing		—		—		—		—
Troubled debt restructurings (“TDR”)		1,030		1,070		682		639
Total nonperforming loans		4,689		4,847		4,195		1,387
OREO		60		72		12		—
Total nonperforming assets	$	4,749	$	4,919	$	4,207	$	1,387

Nonperforming loans at June 30, 2016 were $4.69 million, including $2.79 million in nonperforming loans acquired from NUVO. Of the $4.69 million in nonperforming loans in the table above there were $3.96 million in commercial and commercial real estate loans, $701 thousand are residential mortgages, and $27 thousand are installment loans.

Our analysis indicates any additional loss exposure on current non-accruing loans is minimal based on a combination of estimated collateral value and a specific allocation of reserve, where needed.

Excluded from the nonperforming balances discussed above are loans that are 31 to 90 days past due, which are not necessarily considered classified or impaired. Accruing loans 31 to 90 days past due as a percentage of total loans as of the periods indicated are presented in the following table:


Period Ended	31-90 Days
June 30, 2016	0.06	%
March 31, 2016	0.28	%
December 31, 2015	0.05	%
June 30, 2015	0.04	%

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Loans, including impaired loans, are generally classified as nonaccrual if they are past due as to maturity or payment of principal or interest for a period of more than 90 days. If a loan or a portion of a loan is internally classified as impaired or is partially charged-off, the loan is generally classified as nonaccrual. Loans that are on a current payment status or past due less than 91 days may also be classified as nonaccrual if repayment in full of principal and/or interest is in doubt. Income accruals are suspended on all non-accruing loans, and all previously accrued and uncollected interest is charged against current income.

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

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

A loan remains in non-accruing 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 non-accruing loan is secured by real estate, we 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 us possession of the collateral in order to manage a future resale of the real estate. Foreclosed property is recorded at the lower of its cost or estimated fair value, less any estimated costs to sell and is actively marketed. 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 statements of income. Nonperforming loans, which primarily consist of non-accruing residential mortgage, commercial, commercial real estate loans and TDRs totaled $4.69 million and $4.20 million at June 30, 2016 and December 31, 2015, respectively. At June 30, 2016, $1.11 million of nonperforming loans had specific reserve allocations totaling $363 thousand.

Substandard loans at June 30, 2016 totaled $39.39 million, of which $34.93 million in loans continue to accrue interest. Loans identified as substandard have well-defined weaknesses that, if not addressed, could result in a loss. These accruing substandard loans have generally continued to pay promptly and Management conducts regularly scheduled comprehensive reviews of the borrowers’ financial condition, payment performance, accrual status and collateral. These reviews also ensure that these troubled accounts are properly administered with a focus on loss mitigation and that any potential loss exposures are appropriately quantified, and reserved for. The findings of this review process are a key component in assessing the adequacy of our loan loss reserve.

Accruing substandard loans at June 30, 2016 reflect a $16.23 million increase in balances since December 31, 2015. At June 30, 2016, accruing substandard loans related to owner-occupied commercial real estate totaled $14.04 million, investor commercial real estate loans totaled $2.75 million, residential investment real estate loans totaled $1.04 million, residential mortgage loans total $124 thousand and $16.98 million in substandard loans are outstanding to corporate borrowers in a variety of different industries. Nineteen borrowers in a variety of industries account for 93% of the total accruing substandard loans.

To date, with very few exceptions, payments due from accruing substandard borrowers have been made as agreed and Management’s ongoing evaluation of these borrowers’ financial condition and collateral indicates a reasonable certainty that these exposures are adequately secured.

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Management monitors asset quality closely and continuously performs detailed and extensive reviews on larger credits and problematic credits identified on the watched asset list, nonperforming asset listings and internal credit rating reports. In addition to frequent financial analysis and review of well-rated and adversely graded loans, 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 and standby letters of credit. The reserves are based on Management's estimate of the amount required to reflect the probable incurred losses in the loan portfolio, based on circumstances and conditions known at each reporting date. We review the adequacy of the reserves quarterly. Factors considered in evaluating the adequacy of the reserves 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, estimated fair values of properties that secure impaired loans and utilization rates of lines of credit.

The adequacy of the reserves are determined using a consistent, systematic methodology, consisting of a review of both specific reserves for loans identified as impaired and general reserves for the various loan portfolio classifications. When a loan is impaired, we determine its impairment loss by comparing the excess, if any, of the loan’s carrying amount over (1) the present value of expected future cash flows discounted at the loan’s original effective interest rate, (2) the observable market price of the impaired loan, or (3) the fair value of the collateral securing a collateral-dependent loan. When a loan is deemed to have an impairment loss, the loan is either charged down to its estimated net realizable value, or a specific reserve is established as part of the overall allowance for loan losses if Management needs more time to evaluate all of the facts and circumstances relevant to that particular loan.

The general allowance for loan losses is a percentage-based reflection of historical loss experience adjusted for qualitative factors 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.

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 increased or diminished, the ALL is adjusted through current earnings. Management believes that the reserves are maintained at an adequate level, in light of historical and current factors, to reflect the level of credit risk in the loan portfolio. Loan loss experience and nonperforming asset data are presented and discussed in relation to their impact on the adequacy of the ALL.

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The following table reflects our loan loss experience and activity in the allowance for loan losses for the periods indicated:


	Three Months			Six Months			Twelve Months			Six Months
	Ended			Ended			Ended			Ended
(In thousands)	June 30, 2016			June 30, 2016			December 31, 2015			June 30, 2015
Average loans during the period	$	1,426,966		$	1,422,338		$	1,240,386		$	1,203,940
Allowance beginning of the period		12,173			12,040			11,833			11,833
Charge-offs:
Commercial, financial & agricultural		(4)			(7)			(29)			(17)
Residential		—			(73)			(112)			(55)
Commercial Real Estate		—			—			—			—
Installment, Other		(36)			(78)			(108)			(43)
Total charge-offs		(40)			(158)			(249)			(115)
Recoveries:
Commercial, financial & agricultural		2			4			34			28
Residential		11			22			52			29
Commercial Real Estate		—			4			2			1
Construction		—			—			—			—
Installment, Other		20			39			52			33
Total recoveries		33			69			140			91
Net recoveries (charge-offs)		(7)			(89)			(109)			(24)
Provision for loan losses		254			469			316			353
Allowance end of period	$	12,420		$	12,420		$	12,040		$	12,162
Ratio of net (charge-offs) recoveries to average loans outstanding		0.00	%		(0.01)	%		(0.01)	%		0.00	%

Components:
Provision for allowance for loan losses	$	254		$	469		$	316		$	353
Provision for reserve for undisbursed lines and letters of credit		(54)			(64)			(66)			(253)
Provision for credit losses	$	200		$	405		$	250		$	100

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


	June 30, 2016		March 31, 2016		December 31, 2015		June 30, 2015
NPL to total loans	0.34	%	0.34	%	0.30	%	0.12	%
NPA to total assets	0.25	%	0.25	%	0.21	%	0.08	%
Allowance for loan losses to total loans	0.89	%	0.86	%	0.85	%	1.01	%
Allowance for loan losses to NPL	265	%	251	%	287	%	877	%

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

Loan Portfolio Monitoring

Our Board of Directors grants loan officers the authority to originate loans on our behalf, subject to certain limitations. The Board of Directors also establishes restrictions regarding the types of loans that may be granted and the distribution of loan types within our portfolio, and sets loan authority limits for lenders. These authorized lending limits are reviewed at least annually and are based upon the lender's knowledge and experience. Loan requests that exceed a lender's authority require the signature of our Senior Lender, the Senior Credit Officer, and/or our President. With the exception of certain municipal loans, all extensions of credit of $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. Short-term Revenue Anticipation and Tax

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Anticipation extensions of credit of $8 million or greater to a municipality are reviewed and approved by the Loan Committee of Merchants Bank’s Board of Directors.

The Loan Committee and the credit department regularly monitor our loan portfolio. The entire loan portfolio, as well as individual loans, is reviewed for loan performance, compliance with internal policy requirements and banking regulations, creditworthiness, and strength of documentation. We monitor loan concentrations by individual borrowers, industries and loan types. As part of the annual credit policy review process, targets are set by loan type for the total portfolio. Credit risk ratings assessing inherent risk in individual loans are assigned to commercial loans at origination and are reviewed by lenders and Management on a periodic basis according to total exposure and risk rating. These internal reviews assess the adequacy of all aspects of credit administration, additionally; we maintain an on-going active monitoring process of loan performance during the year. We have also hired external loan review firms to assist in monitoring the commercial, municipal, construction and residential loan portfolios. The commercial loan review firm reviews a minimum threshold of our commercial loan portfolio each year. These comprehensive reviews assessed the accuracy of our risk rating system as well as the effectiveness of credit administration in managing overall credit risks.

All loan officers are required to service their loan portfolios and account relationships. Loan officers, a commercial workout officer, or collection 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.

Liquidity and Capital Resource Management

General

Liquid assets are maintained at levels considered adequate to meet our liquidity needs. Liquidity is adjusted as appropriate to meet asset and liability management objectives. Liquidity is monitored by the Asset and Liability Committee (“ALCO”) of Merchants Bank’s Board of Directors, based upon Merchants Bank’s policies. Our primary sources of liquidity are deposits, amortization and prepayment of loans, maturities of investment securities and other short-term investments, periodic principal repayments on mortgage-backed and other amortizing securities, advances from the FHLB, and earnings and funds provided from operations. While scheduled principal repayments on loans are a relatively predictable source of funds, deposit flows and loan prepayments are greatly influenced by market interest rates, economic conditions, and rates offered by our competition. Interest rates on deposits are priced to maintain a desired level of total deposits.

As of June 30, 2016, we could borrow up to $55 million in overnight funds through unsecured borrowing lines established with correspondent banks. In addition, we have established both overnight and longer term lines of credit with the FHLB. These borrowings are secured by residential mortgage loans. At June 30, 2016, we pledged loans with a carrying value of $367.46 million which carries a $260.24 million borrowing capacity at the FHLB, less borrowings and letters of credit of $87.13 million, resulting in quarter-end capacity of $173.11 million. At December 31, 2015, we pledged loans with a carrying value of $369.78 million which carried a $262.17 million borrowing capacity at the FHLB, less borrowings and letters of credit of $15.25 million, resulting in year-end capacity of $246.92 million. We also have the ability to borrow through the use of repurchase agreements, collateralized by our investments, with certain approved counterparties. Our investment portfolio, which is managed by the ALCO, had a carrying amount of $385.48 million at June 30, 2016, of which $321.13 million was pledged. The portfolio is a reliable source of cash flow for us. We closely monitor our short term cash position. Any excess funds are either left on deposit at the Federal Reserve Bank, or are in a fully insured account with one of our correspondent banks.

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Presented below are our short-term borrowings during the periods indicated:


	Three Months Ended			Six Months Ended
(Dollars in thousands)	June 30, 2016			June 30, 2016
FHLB and other short-term borrowings
Amount outstanding at end of period	$	70,000		$	70,000
Maximum during the period amount outstanding		104,999			104,999
Average amount outstanding		24,906			12,454
Weighted average-rate during the period		0.49	%		0.49	%
Weighted average rate at period end		0.47	%		0.47	%
Securities sold under agreement to repurchase, short-term
Amount outstanding at end of period	$	184,920		$	184,920
Maximum during the period amount outstanding		274,073			286,639
Average amount outstanding		235,927			247,963
Weighted average-rate during the period		0.18	%		0.17	%
Weighted average rate at period end		0.15	%		0.15	%

Commitments and Off-Balance Sheet Risk

We are a party to financial instruments with off‑balance sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments primarily include commitments to extend credit and financial guarantees. Contingent obligations under standby letters of credit totaled approximately $6.23 million and $6.30 million at June 30, 2016 and December 31, 2015, respectively, and represent the maximum potential future payments we could be required to make. Typically, these instruments have terms of 12 months or less and expire unused: therefore, the total amounts do not necessarily represent future cash requirements. The fair value of our standby letters of credit at June 30, 2016 and December 31, 2015 was insignificant.

Capital Resources

We are subject to various regulatory capital requirements administered by federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on our financial statements. Under capital adequacy guidelines, we must meet specific capital guidelines that involve quantitative measures of our assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. It is the policy of the Board of Governors of the Federal Reserve System (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. The FRB has the authority to prohibit a bank holding company, such as us, from paying dividends if it deems such payment to be an unsafe or unsound practice. The FDIC has the authority to use its enforcement powers to prohibit a bank from paying dividends if, in its opinion, the payment of dividends would constitute an unsafe or unsound practice. Federal law also prohibits the payment of dividends by a bank that will result in the bank failing to meet its applicable capital requirements on a pro forma basis. We are also subject to the regulatory framework for prompt corrective action that requires us to meet specific capital guidelines to be considered well capitalized. Our capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

Quantitative measures established by regulation to ensure capital adequacy require us to maintain minimum ratios of common equity, total and Tier 1 capital to risk-weighted assets and of Tier 1 capital to average assets. Management believes, as of June 30, 2016, that Merchants met all capital adequacy requirements to which it is subject.

Under rules effective January 1, 2015, a bank holding company, such as Merchants Bancshares, is considered well capitalized if the bank holding company (i) has a total risk based capital ratio of at least 10%, (ii) has a Tier 1 risk-based capital ratio of at least 8%, and (iii) is not subject to any written agreement order, capital directive or prompt corrective action directive to meet and maintain a specific capital level for any capital measure. In addition, the FDIC has amended its prompt corrective action rules to reflect the new capital rules. Under the FDIC’s revised rules, which became effective January 1, 2015, an FDIC supervised institution, such as Merchants Bank is considered well capitalized if it (i) has a total

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risk-based capital ratio of 10.0% or greater; (ii) a Tier 1 risk-based capital ratio of 8.0% or greater; (iii) a common Tier 1 equity ratio of at least 6.5% or greater, (iv) a leverage capital ratio of 5.0% or greater; and (iv) is not subject to any written agreement, order, capital directive, or prompt corrective action directive to meet and maintain a specific capital level for any capital measure. The final rule also requires unrealized gains and losses on certain “available-for-sale” securities holdings to be included for purposes of calculating regulatory capital requirements unless a one-time opt-out is exercised. Merchants elected to opt-out of this regulatory capital provision. By opting out of the provision, Merchants retains what is known as the accumulated other comprehensive income filter. The final rule limits a banking organization’s capital distributions and certain discretionary bonus payments if the banking organization does not hold a “capital conservation buffer” in addition to the amount necessary to meet its minimum risk-based capital requirements. The phase-in period for the “capital conservation buffer” requirement begins January 1, 2016 with a requirement to be 0.625% above the minimum risk-based capital requirements. When fully phased in on January 1, 2019, banks must maintain a “capital conservation buffer” of 2.50%.

As of June 30, 2016, the most recent notification from the FDIC categorized Merchants Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that Management believes have changed Merchants Bank’s category.

The following table summarizes Merchants’ and Merchants Bank’s capital ratios in comparison to the regulatory requirements:


									To Be Well-
									Capitalized Under				Fully Phased-in,
	Actual				For Capital				Prompt Corrective				with Capital
	June 30, 2016				Adequacy Purposes				Action Provisions				Conservation Buffers
(In thousands)	Amount		Percent		Amount		Percent		Amount		Percent		Amount		Percent
Merchants Bancshares, Inc.:
Tier 1 Leverage Capital	$	170,092	8.77	%	$	77,589	4.00	%		N/A	N/A			N/A	N/A
Tier 1 Risk-Based Capital		170,092	14.76	%		69,151	6.00	%		N/A	N/A		$	97,964	8.50	%
Total Risk-Based Capital		183,364	15.91	%		92,201	8.00	%		N/A	N/A			121,014	10.50	%
Common Equity Tier 1 Capital		150,092	13.02	%		51,863	4.50	%		N/A	N/A			80,676	7.00	%

Merchants Bank:
Tier 1 Leverage Capital	$	167,983	8.65	%	$	77,714	4.00	%	$	97,142	5.00	%		N/A	N/A
Tier 1 Risk-Based Capital		167,983	14.51	%		69,453	6.00	%		92,605	8.00	%	$	98,392	8.50	%
Total Risk-Based Capital		181,254	15.66	%		92,605	8.00	%		115,756	10.00	%		121,544	10.50	%
Common Equity Tier 1 Capital		167,983	14.51	%		52,090	4.50	%		75,241	6.50	%		81,029	7.00	%

Capital amounts for Merchants Bancshares, Inc. include $20.62 million in trust preferred securities issued in December 2004. These hybrid securities qualify as Tier 2 capital up to certain regulatory limits.

Item 3 – Quantitative and Qualitative Disclosures about Market Risk

Risk Management

General

Our Management and Board of Directors are committed to sound risk management practices throughout the organization. We have developed and implemented a risk management monitoring program. Risks associated with our business activities and products are identified and measured as to probability of occurrence and impact on us (low, moderate, or high), and the control or other activities in place to manage those risks are identified and assessed. Periodically, department-level and senior managers re-evaluate and report on the risk management processes for which they are responsible. This documented program provides us with a comprehensive framework for monitoring our risk profile from a macro perspective.

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It also serves as a tool for assessing internal controls over financial reporting as required under the Federal Deposit Insurance Act and the Sarbanes-Oxley Act of 2002.

Effective May 26, 2016, the Bank Board of Directors established the Enterprise Risk Management Committee. The Enterprise Risk Management Committee assists the Board in oversight of the Bank’s enterprise-wide risk management framework and associated policies and practices, risk profile and risk appetite and tolerance, and regulatory compliance program.

Market Risk

Market risk is the risk of loss in a financial instrument arising from adverse changes in market rates or prices such as interest rates, foreign currency exchange rates, commodity prices, and equity prices. Our primary market risk exposure is interest rate risk. An important component of our asset and liability management process is the ongoing monitoring and management of this risk, which is governed by established policies that are reviewed and approved annually by our Board of Directors. Our Investment Policy details the types of securities that may be purchased, and establishes portfolio limits and maturity limits for the various sectors. The Investment Policy also establishes specific investment quality limits. Our Board of Directors has established a Board-level Asset/Liability Committee (“ALCO”), which delegates responsibility for carrying out the asset/liability management policies to the Management-level Asset/Liability Committee (the “Management ALCO”). The Management ALCO, chaired by the Chief Financial Officer and composed of members of senior management, develops guidelines and strategies impacting our asset and liability management related activities based upon estimated market risk sensitivity, policy limits and overall market interest rate levels and trends. The Management ALCO manages the investment portfolio. As the portfolio has grown, the Management ALCO has used portfolio diversification as a way to mitigate the risk of being too heavily invested in any single asset class. We continued to work to maximize net interest income while mitigating risk during the year 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.

Liquidity Risk

Our liquidity is measured by our ability to raise cash when needed at a reasonable cost. We must be capable of meeting expected and unexpected obligations to customers at any time. Given the uncertain nature of customer demands as well as the need to maximize earnings, we must have available reasonably priced sources of funds, on- and off-balance sheet, which can be accessed quickly in time of need. As discussed above under Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resource Management,” we have several sources of readily available funds, including the ability to borrow using our investment portfolio as collateral. We also monitor our liquidity on a quarterly basis in compliance with our Liquidity Contingency Plan. Our liquidity monitoring process identifies early liquidity stress triggers, and also allows us to model worst case liquidity scenarios, and various responses to those scenarios.

Interest Rate Risk

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

The ALCO is responsible for evaluating and managing the interest rate risk which arises naturally from imbalances in repricing, maturity and cash flow characteristics of our assets and liabilities. Techniques used by the ALCO take into consideration the cash flow and repricing attributes of balance sheet and off-balance sheet items and their relation to possible changes in interest rates. The ALCO manages interest rate exposure by using a combination of on-balance sheet and off-balance sheet strategies. On-balance sheet strategies generally consist of management of the duration, rate sensitivity and average lives of our various investments, and by extending or shortening maturities of borrowed funds, as well as carefully managing and monitoring the pricing and average lives of loans and the pricing and maturity of deposits. We also use off-balance sheet strategies, such as interest rate swaps and interest rate caps and floors, to help minimize our exposure to changes in interest rates. By using derivative financial instruments to hedge exposures to changes in interest

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rates we are exposed to credit risk and market risk. Credit risk is the failure of the counterparty to perform under the terms of the derivative contract. When the fair value of a derivative contract is positive, the counterparty owes us, creating credit risk. We minimize credit risk in derivative instruments by entering into transactions only with high-quality counterparties. The market risk associated with interest-rate contracts is managed by establishing and monitoring parameters that limit the types and degree of market risk that may be undertaken.

The ALCO is responsible for ensuring that our Board of Directors receives accurate information regarding our interest rate risk position at least quarterly. The investment advisory firm and ALCO consultant meet collectively with the board and Management-level ALCOs on a quarterly basis. During these meetings the ALCO consultant reviews our current position and discusses future strategies, as well as reviewing the result of rate shocks of our 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.

The ALCO consultant’s most recent review was as of June 30, 2016. The consultant ran a base simulation assuming no changes in rates as well as a 200 basis point rising and, because rates continue to be very low, a 100 basis point falling interest rate scenario that assumes a parallel and pro rata shift of the yield curve over a one-year period, and no growth assumptions. Additionally, the consultant ran a 400 basis point rising simulation that assumed a parallel shift of the curve over 24 months, a 500 basis point rising simulation which assumed the curve flattened over a 24 month time frame, and a 500 basis point rising simulation which assumed the increase in rates was delayed by two years. A summary of the results is as follows:

Current/Flat Rates: Net interest income levels are projected to trend downward throughout the simulation. The sustained low rate environment causes continued margin pressures as assets continue to reprice, and are replaced at lower rates than the existing portfolio, while funding costs are at or near their floors.

Falling Rates: If rates fall 100 basis points our net interest income is projected to trend downward through the simulation. Margins and income decline as asset yields continue to reprice lower with no relief on the funding side.

Rising Rates: Net interest income is projected to increase throughout the simulation given a rise in rates regardless of the shape of the yield curve because our interest rate risk position is structurally asset sensitive due to our strong core funding position which supports a shorter term asset base. If rates remain at current low levels for another two years, the benefit of rising rates is muted because the starting point for asset yields will be lower.

We have established a target range for the change in net interest income in year one of zero to 7.5%. The net interest income simulation as of June 30, 2016 showed that the change in net interest income for the next 12 months from our expected or “most likely” forecast was as follows:


	Percent Change in Net
Rate Change	Interest Income
Up 200 basis points	1.90	%
Down 100 basis points	(2.70)	%

The change in net interest income in the second year of the simulation shows a more pronounced downward trend in the flat and down 100 basis points scenarios, the projected change is (4.5)% and (15.5)%, respectively, while the up 200 basis points simulation produces an increase of 4.6%. The degree to which this exposure materializes will depend, in part, on our ability to manage our balance sheet as interest rates rise or fall.

Actual results may differ materially from those projected. 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. 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 our balance sheet. The model incorporates product specific loan prepayment assumptions and uses contractual repricing dates for variable

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rate loan products and contractual maturities for fixed rate products. The model uses product-specific assumptions for deposits which are subject to repricing based on current market conditions. The model uses the Yield Book, Inc. system to analyze the investment portfolio which produces bond specific cash flows forecasts for each rate scenario tested in the analysis. The analysis details bond maturity, amortization, repricing characteristics, and optionality. The cash flow forecasts take into consideration assumptions for absolute rate movements, the period over which rates are assumed to shift and assumed changes in the shape of the yield curve. The model also assumes that the rate at which residential mortgage related assets prepay will vary as rates rise and fall, based on prepayment estimates derived from Applied Financial Technologies.

The preceding sensitivity analysis does not represent our 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, we cannot make any assurances as to the predictive nature of these assumptions including how customer preferences or competitor influences might change. As market conditions vary from those assumed in the sensitivity analysis, actual results will likely differ due to: the varying impact of changes in the balances and mix of loans and deposits differing from those assumed, the impact of possible off balance sheet hedging strategies, and other internal/external variables. Furthermore, the sensitivity analysis does not reflect all actions that the ALCO might take in responding to or anticipating changes in interest rates.

The most significant ongoing factor affecting market risk exposure of net interest income during the quarter ended June 30, 2016 was the sustained low interest rate environment. Net interest income exposure is also significantly affected by the shape and level of the U.S. Government securities and interest rate swap yield curves, and changes in the size and composition of the loan, investment and deposit portfolios.

Credit Risk

The Board of Directors reviews and approves our 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 our portfolio. Our 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. Our policy is to discontinue the accrual of interest on loans when scheduled payments become contractually past due 91 or more days and the ultimate collectability of principal or interest become doubtful. In certain instances the accrual of interest is discontinued prior to 91 days past due if Management determines that the borrower will not be able to continue making timely payments.

Item 4 – Controls and Procedures

Our principal executive officer, interim principal financial officer, and other members of our senior management have evaluated our disclosure controls and procedures as of the end of the period covered by this quarterly report. Based on this evaluation, our principal executive officer and interim principal financial officer have concluded that the disclosure controls and procedures effectively ensure that information required to be disclosed in our filings and submissions with the SEC under the Securities Exchange Act of 1934, as amended, is accumulated and communicated to our management (including the principal executive officer and interim principal financial officer), and is recorded, processed, summarized and reported within the time periods specified by the SEC. In addition, we have reviewed our internal control over financial reporting and there have been no changes in our internal control over financial reporting during the quarter ended June 30, 2016 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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MERCHANTS BANCSHARES, INC.

PART II – OTHER INFORMATION

Item 1 – Legal Proceedings

We are involved in various legal proceedings arising from our normal business activities. In the opinion of Management, based upon input from counsel on the anticipated outcome of such proceedings, final disposition of these proceedings will not have a material adverse effect on our consolidated financial position.

Item 1a – Risk Factors

In addition to the other information set forth in this report, please read the factors discussed in Part I – Item 1A, "Risk Factors" in our Annual Report on Form 10-K for the fiscal year ended December 31, 2015 filed with the SEC on March 14, 2016, which could materially adversely affect our business, financial condition and operating results. These risks are not the only ones facing us. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and operating results.

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

None.

Item 3 – Defaults on Senior Securities

None.

Item 4 – Mine Safety Disclosure

Not applicable.

Item 5 – Other Information

None.

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PART IV

Item 6 – Exhibits

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


Exhibit		Description

10.1		Employment Agreement by and between Merchants, Merchants Bank and Anita Bourgeois, entered into on May 26, 2016+*

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

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

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

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

101		The following materials from Merchants Bancshares, Inc.’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2016 formatted in XBRL: (i) Consolidated Balance Sheets at June 30, 2016 and December 31, 2015; (ii) Consolidated Statements of Income for the three and six months ended June 30, 2016 and 2015; (iii) Consolidated Statements of Comprehensive Income for the three and six months ended June 30, 2016 and 2015; (iv) Consolidated Statements of Cash Flows for the six months ended June 30, 2016 and 2015; and (v) Notes to Interim Unaudited Consolidated Financial Statements.*

+ Management contract or compensatory plan or agreement

* Filed herewith

** Furnished herewith

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SIGNATURES

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


		Merchants Bancshares, Inc.

		/s/ Geoffrey R. Hesslink
		Geoffrey R. Hesslink President and Chief Executive Officer

		/s/ Eric A. Segal
		Eric A. Segal Interim Principal Financial Officer, Principal Accounting Officer and Treasurer

		August 3, 2016
		Date

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