ITEM 1 - -BUSINESS
GENERAL
Merchants Bancshares, Inc. is a bank holding company originally organized under Vermont law in 1983 (and subsequently reincorporated in Delaware) for the purposes of owning all of the outstanding capital stock of Merchants Bank and providing greater flexibility in helping Merchants achieve its business objectives. Merchants Bank, which is Merchants' primary subsidiary, is a Vermont commercial bank with 35 full-service banking offices.
The Merchants Bank was organized in 1849 and assumed a national bank charter in 1865, becoming The Merchants National Bank of Burlington, Vermont. On September 6, 1974, The Merchants National Bank of Burlington converted its national charter to a Vermont state commercial bank charter, adopting its current name, Merchants Bank. As of December 31, 2004, Merchants operated one of the largest commercial banking operations in Vermont, with deposits totaling $834 million, gross loans of $584 million, and total assets of $1.03 billion.
Merchants Trust Company, a wholly owned subsidiary of Merchants Bank, is a Vermont corporation chartered in 1870 for the purpose of offering fiduciary services including trust management and administration, investment management and estate settlement services. As of December 31, 2004, Merchants Trust Company had fiduciary responsibility for assets having a market value in excess of $417 million, of which more than $297 million constituted managed assets. Total revenue of Merchants Trust Company for 2004 was $1.5 million and total expenses were $1.1 million.
Merchants Properties, Inc., a wholly owned subsidiary of Merchants, was organized for the purpose of developing and owning affordable rental housing units throughout the state of Vermont. As of December 31, 2004, Merchants Properties, Inc. owned one development located in Enosburg, Vermont, consisting of a 24-unit low-income family rental housing project. Total assets of Merchants Properties, Inc. at December 31, 2004 were $1.0 million.
MBVT Statutory Trust I was formed on December 15, 2004 as part of Merchants' private placement of an aggregate of $20 million of trust preferred securities through a pooled trust preferred program. The trust was formed for the sole purpose of issuing non-voting capital securities. The proceeds from the sale of the capital securities were loaned to Merchants under deeply subordinated debentures issued to the Trust. The debentures are the only asset of the Trust and payments under the debentures are the sole revenue of the Trust.
RETAIL SERVICES
Merchants' products are designed to provide high value within a relatively narrow range of offerings. Individual categories are anchored by lead products that are attractively packaged and easy for Merchants' staff to deliver. This is a clear contrast to most of the other local, regional and national financial service providers. Merchants has consciously stayed away from business lines that are not supportable at the most competitive standard. The business lines it has chosen are fully supported, with employees proficient in selling and servicing all programs. Merchants' customers appreciate the value that is offered via well defined product features and services that function in a straightforward, effective manner. That formula, in combination with highly motivated and well-trained front line professionals, provides the company with a competitive advantage in its markets.
Merchants' retail products include interest bearing and non-interest bearing checking accounts, money market accounts, club accounts, and short-term and long-term certificates of deposit. Merchants also offers customary check collection services, wire transfers, safe deposit box rentals, and automated teller machine ("ATM") and debit cards. Credit programs include secured and unsecured installment lending, home equity lines of credit, and home mortgages.
Free Checking For Life® is available to all applicants of "good standing" in Merchants' market area, and is free of monthly service charges for the life of the account. The only condition to holding the account is that the customer accept check truncation. The account pays interest at tiered levels beginning with the first dollar, and no minimum balance is required. Merchants opened just over 9,600 Free Checking For Life® accounts during 2004.
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Free Checking For Life® customers may choose either a Check Card or an ATM card. Customers who choose the Check Card can pay for purchases at locations that accept VISA®. Customers can use a money market account and/or a home equity line of credit as overdraft protection for a checking account. The customer may choose either or both accounts to cover overdrafts via an automatic transfer of funds ("ATF").
Merchants' other major retail deposit product is its MoneyLYNX® Money Market Account. MoneyLYNX® pays interest at tiered levels beginning with the first dollar in the account, and fees are charged only under certain limited circumstances. Merchants' rates on this product remained competitive during the last year, but were not at the top of the market. New account activity rose during 2004, with average individual account balances leveling. At the beginning of 2004 the product was enhanced by lowering the minimum balance required to open an account, contributing to greater demand for this offering.
Merchants' flexible TimeLYNX® certificate of deposit allows multiple deposits and penalty free withdrawals within regulatory guidelines. It is an attractive alternative for customers who wish to retain some of the liquidity features of a money market or savings account while receiving a higher yield than what is offered by those accounts.
Merchants offers ATF to cover overdrafts, electronic funds transfer ("EFT") to automate transfers between accounts, and the PhoneLYNXSM telephone banking system. Merchants offers eLYNX®, a free online banking service as well as a free bill payment service delivered via the Internet, which has proven to be a popular addition.
Each of Merchants' 35 full-service branch offices is led by a branch president who has responsibility for the full range of retail and small business credit services. Merchants' semi-autonomous branch system is core to its strategy of providing one-stop shopping to its customers. Currently most customer inquiries can be handled at any branch location. The branch serves as both a sales and a delivery outlet. Branch personnel can explain various deposit options and open new accounts online via internal systems. Additionally, qualified branch staff have the ability to take loan applications, approve loans within defined approval limits, and to close consumer, mortgage and small business loans. Merchants also operates 41 ATMs throughout Vermont, and maintains a customer call center with expanded hours of operation.
With the cycle of refinancing diminishing during 2004, there was less activity in real estate loan originations. Work was done to build relationships with all Merchants households via a communication process known as XSell. More of the mortgage and home equity options were introduced to customers. Financing is available for one-to-four-family residential mortgages, multifamily residential mortgages, residential construction, seasonal dwelling mortgages, and commercial real estate mortgages. Merchants offers both fixed rate and adjustable rate mortgages for residential properties. Merchants currently holds all originated mortgages in its loan portfolio.
Following the success of RealLYNX®-10 in 2003, Merchants launched a new four-year closed end home equity line of credit in February 2004 and also enhanced its seven-year closed end home equity loan. Merchants offers a wide variety of consumer loans. Financing is provided for new or used automobiles, boats, airplanes, recreational vehicles and new mobile homes. Home improvement and home equity lines of credit and various personal loans are also available.
COMMERCIAL SERVICES
Merchants' corporate sales staff services the majority of the commercial customers, which are primarily larger operating companies, real estate investors and developers. Ten corporate banking officers and ten corporate banking administrators provide commercial credit services throughout Vermont to customers requiring business credit above the prescribed authorities of the branch presidents. Branch presidents are trained for small business loan origination.
Financing is available for business inventory, accounts receivable, fixed assets, real estate, lines of credit for working capital, community development, irrevocable letters of credit, U.S. Small Business Administration guaranteed loans and USDA guaranteed loans. Merchants has increased the emphasis placed on small business loans originated in its branches. During the fourth quarter of 2003 Merchants introduced QLYNX, a streamlined three-year, secured, term loan targeted to customers looking for amounts up to $75 thousand.
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CommerceLYNX® is a package of business banking services including a low cost business checking account, a CommerceLYNX® Money Market Account, and a streamlined overdraft protection line of credit application. Merchants' philosophy of simplifying product offerings and minimizing fees has been applied to this program. Consistent with Merchants' goal of promoting electronic transactions, CommerceLYNX® provides Internet banking, bill payment and debit and electronic services. Branch presidents are trained to offer this service leading with the introduction of small business financing options and the value of utilizing the efficient transaction accounts.
Merchants offers a variety of commercial checking accounts. Commercial checking uses an earnings credit rate to help offset service charges. Merchants offers the CommerceLYNX® Money Market Account as the savings vehicle for businesses. The CommerceLYNX® Money Market Account pays interest at tiered levels beginning with the first dollar in the account. Merchants' cash management services provide additional investment opportunities through the Cash Sweep Program. Other cash management services include funds concentration. Merchants offers eLYNX® Online Banking, a commercial banking and bill payment service delivered via the Internet. These products allow businesses to view their account histories, print statements, view check images, order stop payments, transfer between accounts, transmit ACH batches, and order wire transfers. Other miscellaneous commercial banking services include night depository, coin and currency handling, and balance reporting services.
COMPETITION
The competitive landscape changed significantly in 2004. Several large credit unions and a mutual savings bank made substantial commitments in new bricks and mortar in our primary markets. This combined with the completion of Royal Bank of Scotland's purchase of Charter One through its U.S. subsidiary Citizens Bank has resulted in a wholesale change in the competitive landscape. It is too soon to determine the impact of the acquisition by Toronto Dominion of a majority interest in Banknorth Group, Inc. It has been our experience that the larger the competitor the better chance we have of gaining market share. Like most financial institutions in America, Merchants competes with an ever increasing array of financial service providers. As the national economy moves further toward a concentration of service companies and the overall health of the financial service industry continues to be strong, competitive pressures will mount. Merchants competes in Vermont for deposit and loan business with numerous other commercial and savings banks, savings and loan associations, credit unions, and other non-bank financial providers. As of December 31, 2004, there were more than 20 state and national banking institutions operating in Vermont. In addition, the number of non-bank financial service providers competing in Vermont has increased dramatically. As a bank holding company and state-chartered commercial bank, Merchants is subject to extensive regulation and supervision, including, in many cases, regulation that limits the type and scope of its activities. The non-bank financial service providers that compete with Merchants may not be subject to such extensive regulation and supervision. Competition from nationwide banks, as well as local institutions, continues to be aggressive.
Merchants expects to see continued competitive pressure on its franchise. Merchants is the largest independent bank with offices exclusively in the state of Vermont. Aggressive and flexible direct marketing of core financial products continues to result in increased market share, even in mature market areas. In 2003, Merchants opened two de novo branches in St. Albans and White River Junction, Vermont. Several smaller community banks have made a commitment to increase their footprints in Merchants' markets. A small mutual savings bank headquartered in the central section of Vermont has moved into Chittenden County with three new retail locations. A small community bank based in the northeast section of Vermont has opened two new branches in the central part of the state. Several of the credit unions have also opened additional branch locations. The impact to Merchants of Bank of America's purchase of Fleet Bank remains to be seen. Bank of America now has branches in the three states that border Vermont; New Hampshire, Massachusetts and upstate New York; they may choose to expand into Vermont. In a state that already has one of the nation's highest branch-to-population ratios it is necessary to have a very competitive product offering and exceptional service levels in order to compete effectively.
From a retail product standpoint, Merchants has seen a major change in the competitive landscape in the past few years. When Merchants' free checking product was introduced there was only one other competitor with a similar product offering. Since that time all but one of Merchants' largest competitors has introduced free checking products. Merchants' free checking product is the only free checking product that pays interest. Merchants continues to see this as the major driver in its new household penetration.
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No material part of Merchants' business is dependent upon one, or a few, customers, or upon a particular industry segment, the loss of which would have a material adverse impact on the operations of Merchants.
NUMBER OF EMPLOYEES
As of December 31, 2004, Merchants Bancshares, Inc. had three officers: Joseph L. Boutin, President and Chief Executive Officer; Janet P. Spitler, Chief Financial Officer and Treasurer; and Lisa Razo, Secretary. No officer of Merchants Bancshares, Inc. is on a salary basis; its officers also serve as officers of Merchants Bank and are paid a salary by the Bank.
As of December 31, 2004, Merchants Bank employed 254 full-time and 54 part-time employees and Merchants Trust Company employed 12 full-time employees, representing a combined full time equivalent complement of 293 employees. Merchants Bank and Merchants Trust Company maintain comprehensive employee benefits programs for employees which provide major medical insurance, hospitalization, dental insurance, long-term and short-term disability insurance, life insurance and a 401(k) Plan. Merchants believes that relations with its employees are good.
REGULATION AND SUPERVISION
General
As a bank holding company registered under the Bank Holding Company Act of 1956, as amended (the "BHCA"), Merchants is subject to extensive regulation and supervision by the Board of Governors of the Federal Reserve System. As a state-chartered commercial bank, Merchants Bank is subject to substantial regulation and supervision by the Federal Deposit Insurance Corporation (the "FDIC") and by applicable Vermont regulatory agencies. To the extent that the following information describes statutory or regulatory provisions, it is qualified in its entirety by reference to those particular statutory provisions. Any change in applicable law or regulation may have a material effect on the business and prospects of Merchants.
Financial Services Modernization
The Gramm-Leach-Bliley Act ("Gramm-Leach"), which significantly altered banking laws in the United States, was signed into law in 1999. Gramm-Leach enabled combinations among banks, securities firms and insurance companies beginning in 2000. As a result of Gramm-Leach, many of the depression-era laws which restricted these affiliations and other activities which may be engaged in by banks and bank holding companies were repealed. Under Gramm-Leach bank holding companies are permitted to offer their customers virtually any type of service that is financial in nature or incidental thereto, including banking, securities underwriting, insurance (both underwriting and agency), and merchant banking.
In order to engage in these new financial activities a bank holding company must qualify and register with the Federal Reserve Board as a "financial holding company" by demonstrating that each of its bank subsidiaries is "well capitalized," "well managed," and has at least a "satisfactory" rating under the Community Reinvestment Act of 1977 ("CRA").
These new financial activities authorized by Gramm-Leach may also be engaged in by a "financial subsidiary" of a national or state bank, except for insurance or annuity underwriting, insurance company portfolio investments, real estate investment and development, and merchant banking, which must be conducted in a financial holding company. In order for the new financial activities to be engaged in by a financial subsidiary of a national or state bank, Gramm-Leach requires the parent bank (and its sister-bank affiliates) to be "well capitalized" and "well managed"; the aggregate consolidated assets of all of that bank's financial subsidiaries may not exceed the lesser of 45% of its consolidated total assets or $50 billion; the bank must have at least a "satisfactory" CRA rating; and, if that bank is one of the 100 largest national banks, it must meet certain financial rating or other comparable requirements. Gramm-Leach establishes a system of functional regulation, under which the federal banking agencies will regulate the banking activities of financial holding companies and banks' financial subsidiaries, the U.S. Securities and Exchange Commission (the "SEC") will regulate their securities activities and state insurance regulators will regulate their insurance activities. Gramm-Leach also provides new protections against the transfer and use by financial institutions of consumers' nonpublic, personal information.
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Bank Holding Company Regulation
Although Merchants believes that it meets the qualifications to become a financial holding company under Gramm-Leach, it has elected to retain its pre-Gramm-Leach bank holding company regulatory status for the present time. This means that Merchants can engage in those activities which are closely related to banking. Merchants is required by the BHCA to file an annual report and additional reports required with the Federal Reserve Board. The Federal Reserve Board also makes periodic inspections of Merchants and its subsidiaries.
The BHCA requires every bank holding company to obtain the prior approval of the Federal Reserve Board before it may acquire substantially all of the assets of any bank, or ownership or control of any voting shares of a bank, if, after such acquisition, it would own or control, directly or indirectly, more than five percent of the voting shares of such bank. Additionally, as a bank holding company Merchants is prohibited from acquiring ownership or control of five percent or more of any class of voting securities of any company that is not a bank, or from engaging in activities other than banking or controlling banks except where the Federal Reserve Board has determined that such activities are so closely related to banking as to be a "proper incident thereto."
Dividends
Merchants Bancshares, Inc. is a legal entity separate and distinct from Merchants Bank and its other non-bank subsidiary. The revenue of Merchants (on a parent company only basis) is derived primarily from interest and dividends paid to it by its subsidiaries. The right of Merchants, and consequently the right of shareholders of Merchants, to participate in any distribution of the assets or earnings of any subsidiary through the payment of such dividends or otherwise is necessarily subject to the prior claims of creditors of the subsidiary (including depositors, in the case of banking subsidiaries), except to the extent that certain claims of Merchants in a creditor capacity may be recognized.
The payment of dividends by Merchants is determined by its Board of Directors based on Merchants' consolidated liquidity, asset quality profile, capital adequacy, and recent earnings history, as well as economic conditions and other factors, including applicable government regulations and policies and the amount of dividends payable to Merchants by its subsidiaries.
It is the policy of the Federal Reserve Board that banks and bank holding companies, respectively, should pay dividends only out of current earnings and only if, after paying such dividends, the bank or bank holding company would remain adequately capitalized. Federal banking regulators also have authority to prohibit banks and bank holding companies from paying dividends if they deem such payment to be an unsafe or unsound practice. In addition, it is the position of the Federal Reserve Board that a bank holding company is expected to act as a source of financial strength to its subsidiary banks.
Vermont law requires the approval of state bank regulatory authorities if the dividends declared by state banks exceed prescribed limits. The payment of any dividends by Merchants' subsidiaries will be determined based on a number of factors, including the subsidiary's liquidity, asset quality profile, capital adequacy and recent earnings history.
Capital Adequacy and Safety and Soundness
Capital Guidelines
. Under the uniform capital guidelines adopted by the Federal banking agencies, in order to be "well capitalized" a financial institution must have a minimum ratio of total capital to risk-adjusted assets of ten percent (including certain off-balance sheet items, such as standby letters of credit), a minimum ratio of Tier 1 capital to total risk-based assets of six percent (comprised of common equity, retained earnings, minority interests in the equity accounts of consolidated subsidiaries and a limited amount of noncumulative perpetual preferred stock, less deductible intangibles), and a minimum leverage ratio of five percent (Tier 1 capital to average quarterly assets, net of goodwill).
Under Federal banking laws, failure to meet the minimum regulatory capital requirements could subject a banking institution to a variety of enforcement remedies available to federal regulatory authorities, including the termination of deposit insurance by the FDIC and seizure of the institution.
Prompt Corrective Action
. The Federal Deposit Insurance Corporation Improvement Act of 1991 (as amended) (the "FDICIA"), provides the Federal banking agencies with broad powers to take prompt corrective action to resolve problems of insured depository institutions, depending upon a particular institution's level of capital. The FDICIA
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establishes five tiers of capital measurement for regulatory purposes ranging from "well capitalized" to "critically undercapitalized." A depository institution may be deemed to be in a capitalization category that is lower than is indicated by its actual capital position under certain circumstances. As of December 31, 2004, Merchants Bank was classified as "well capitalized" under the applicable prompt corrective action regulations.
Under the FDICIA a depository institution that is "well capitalized" may accept brokered deposits. A depository institution that is adequately capitalized may accept brokered deposits only if it obtains the approval of the FDIC, and may not offer interest rates on deposits "significantly higher" than the prevailing rate in its market. An "undercapitalized" depository institution may not accept brokered deposits. Merchants had no brokered deposits at December 31, 2004.
Safety and Soundness Standard.
The FDICIA, as amended, directs each Federal banking agency to prescribe safety and soundness standards for depository institutions relating to internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, asset-quality, earnings and stock valuation. The Community Development and Regulatory Improvement Act of 1994 amended the FDICIA by allowing Federal banking activities to publish guidelines rather than regulations concerning safety and soundness.
The FDICIA also contains a variety of other provisions that may affect Merchants' operations, including reporting requirements, regulatory guidelines for real estate lending, "truth in savings" provisions, and the requirement that a depository institution give 90 days prior notice to customers and regulatory authorities before closing any branch.
Community Reinvestment Act
Pursuant to the CRA and similar provisions of Vermont law, regulatory authorities review the performance of Merchants in meeting the credit needs of the communities it serves. The applicable regulatory authorities consider compliance with this law in connection with the applications for, among other things, approval for de novo branches, branch relocations and acquisitions of banks and bank holding companies. Merchants received a "satisfactory" rating at its most recent CRA examination.
Interstate Banking Act
The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, as amended (the "Interstate Banking Act"), generally permits bank holding companies to acquire banks in any state, and preempts all state laws restricting the ownership by a bank holding company of banks in more than one state. The Interstate Banking Act also permits a bank to merge with an out-of-state bank and convert any offices into branches of the resulting bank if both states have not opted out of interstate branching; permits a bank to acquire branches from an out-of-state bank if the law of the state where the branches are located permits the interstate branch acquisition; and permits banks to establish and operate de novo interstate branches whenever the host state opts-in to de novo branching. Bank holding companies and banks seeking to engage in transactions authorized by the Interstate Banking Act must be adequately capitalized and managed.
USA Patriot Act
Under Title III of the USA Patriot Act, also known as the "International Money Laundering Abatement and Anti-Terrorism Financing Act of 2001," all financial institutions are required in general to identify their customers, adopt formal and comprehensive anti-money laundering programs, scrutinize or prohibit altogether certain transactions of special concern, and be prepared to respond to inquiries from U.S. law enforcement agencies concerning their customers and their transactions. Additional information-sharing among financial institutions, regulators, and law enforcement authorities is encouraged by the presence of an exemption from the privacy provisions of Gramm-Leach for financial institutions that comply with this provision and the authorization of the Secretary of the Treasury to adopt rules to further encourage cooperation and information-sharing. The effectiveness of a financial institution in combating money laundering activities is a factor to be considered in any application submitted by the financial institution under the Bank Merger Act and Bank Holding Company Act.
Sarbanes-Oxley Act of 2002
The Sarbanes-Oxley Act of 2002, signed into law July 30, 2002, addresses, among other issues, corporate governance, auditor independence and accounting standards, executive compensation, insider loans, whistleblower protection and
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enhanced and timely disclosure of corporate information. The SEC has adopted a substantial number of implementing rules, and the New York Stock Exchange and the National Association of Securities Dealers, Inc. have adopted corporate governance rules that have been approved by the SEC. The changes are intended to allow shareholders to monitor more effectively the performance of companies and management.
As directed by Section 302(a) of the Sarbanes-Oxley Act of 2002, Merchants' chief executive officer and chief financial officer are each required to certify that Merchants' quarterly and annual reports do not contain any untrue statement of a material fact. This requirement has several parts, including certification that these officers are responsible for establishing, maintaining and regularly evaluating the effectiveness of Merchants' internal disclosure controls and procedures and internal control over financial reporting. The officers certify that they have made certain disclosures to Merchants' auditors and the Audit Committee of the board of directors about Merchants' internal disclosure controls and procedures and internal control over financial reporting and that they have included information in Merchants' quarterly and annual reports about their evaluation of those controls. In addition, the officers also certify in this report whether there have been any significant changes in Merchants' internal disclosure controls and procedures, internal controls over financial reporting, or in other factors that could significantly affect, that has materially affected, or is reasonably likely to materially affect, Merchants' internal disclosure controls and procedures and internal controls over financial reporting and compliance with certain other disclosure obligations.
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350, Merchants' chief executive officer and chief financial officer are each required to certify that Merchants' quarterly and annual reports fully comply with the requirements of Sections 13(a) or 15(d) of the Securities Exchange Act and that the information contained in the report fairly presents, in all material respects, Merchants' financial condition and results of operations.
Other Proposals
Other legislative and regulatory proposals regarding changes in banking, the regulation of banks and other financial institutions, and public companies generally, are regularly considered by the executive branch of the Federal government, Congress and various state governments, including Vermont, and state and federal regulatory authorities. It cannot be predicted what additional legislative and/or regulatory proposals, if any, will be considered in the future, whether any such proposals will be adopted or, if adopted, how any such proposals would affect Merchants.
Available Information
Merchants files annual, quarterly, and current reports, proxy statements, and other documents with the SEC under the Securities Exchange Act of 1934 (the "Exchange Act"). The public may read and copy any materials that Merchants has filed with the SEC at the SEC's Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. Also, the SEC maintains an Internet website that contains reports, proxy and information statements, and other information regarding issuers, including Merchants, that file electronically with the SEC. The public can obtain any documents that Merchants has filed with the SEC at http://www.sec.gov.
Merchants also makes available free of charge on or through its Internet website (http://www.mbvt.com) its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and, if applicable, amendments to those reports filed or furnished pursuant to Section 13(a) of the Exchange Act, as soon as reasonably practicable after Merchants electronically files such materials with or furnishes them to, the SEC. Merchants also makes all filed insider transactions available through its website free of charge. In addition, Merchants' Audit Committee and Nominating and Governance Committee Charters as well as its Code of Ethics Policy for Senior Financial Officers are available free of charge on its website.
ITEM 2
ITEM 2 - -PROPERTIES
As of December 31, 2004, Merchants operated 35 full-service banking offices, and 41 ATMs throughout the state of Vermont. Merchants' headquarters are located in Merchants' service center at 275 Kennedy Drive, South Burlington, Vermont, which also houses Merchants' administrative offices, the operations data processing center and Merchants Trust Company.
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ITEM 6
ITEM 6 - -SELECTED FINANCIAL DATA
The supplementary financial data presented in the following tables contain information highlighting certain significant trends in Merchants' financial condition and results of operations over an extended period of time.
The following information should be analyzed in conjunction with Item 7
ITEM 7 - -MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
CRITICAL ACCOUNTING POLICIES
Management's discussion and analysis of Merchants' financial condition is based on the consolidated financial statements which are prepared in accordance with accounting principles generally accepted in the United States. The preparation of such consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. Management evaluates its estimates on an ongoing basis. Management bases its estimates on historical experience and various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis in making judgments about financial statement amounts. Actual results could differ from the amount derived from management's estimates and assumptions under different assumptions or conditions.
Merchants' significant accounting policies are described in more detail in Note 1 to the consolidated financial statements included in Item 8 of this Form 10-K. Management believes the following accounting policies are the most critical to the preparation of the consolidated financial statements.
Allowance for Loan Losses:
The allowance for loan losses, which is established through the provision for loan losses, is based on management's evaluation of the level of allowance required in relation to the estimated loss exposure in the loan portfolio. Management believes the allowance for loan losses is a significant estimate and therefore evaluates it for adequacy each quarter. Management considers factors such as previous loss experience, the size and composition of the loan portfolio, current economic and real estate market conditions, the performance of individual loans in relation to contract terms, and estimated fair value of collateral that secures the loans. The use of different estimates or assumptions could produce a different allowance for loan losses.
Income Taxes:
Merchants estimates its income taxes for each period for which a statement of operations is presented. This involves estimating Merchants' actual current tax exposure, as well as assessing temporary differences resulting from differing timing of recognition of expenses, income and tax credits, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in Merchants' consolidated balance sheets. Merchants must also assess the likelihood that any deferred tax assets will be recovered from future taxable income and to the extent that recovery is not likely a valuation allowance must be established. Significant management judgment is required in determining income tax expense, and deferred tax assets and liabilities. As of December 31, 2004, there was no valuation allowance for deferred tax assets.
Interest Income Recognition on Loans:
Interest on loans is included in income as earned based upon the unpaid principal balance of the loan. Merchants' policy is to discontinue the accrual of interest, and to reverse any uncollected interest recorded on loans, when scheduled payments become contractually past due in excess of 90 days unless the ultimate collectibility of principal and interest is assured.
GENERAL
The following discussion and analysis of financial condition and results of operations of Merchants and its subsidiaries for the three years ended December 31, 2004, should be read in conjunction with the Consolidated Financial Statements and Notes thereto and selected statistical information appearing elsewhere in this Form 10-K. The information about asset yields, interest rate spreads and net interest margins is discussed on a fully taxable equivalent basis. The financial condition and operating results of Merchants essentially reflect the operations of its principal subsidiary, Merchants Bank. Certain statements contained in this section constitute "Forward-Looking Statements" and are subject to certain risks and uncertainties described in this 10-K under the heading "Forward-Looking Statements".
OUTLOOK
Merchants' market area generally witnessed an increase in economic growth throughout 2004. Job growth during 2004 is estimated to be in the 1.5% to 2% range. The housing market had a strong year during 2004 and there are several large scale public and private sector construction projects underway. Vermont's seasonally adjusted unemployment
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rate closed the year at 3.4%, compared to 4.7% at the end of 2003. The national unemployment rate at the end of 2004 was 5.4%. The Federal Reserve Board increased its target for the federal funds rate by 125 basis points in the second half of 2004, but indicated that it believes that inflation pressure is still relatively low. The economies and real estate markets in Merchants' primary market areas will continue to be significant determinants of the quality of Merchants' assets in future periods and, thus, its results of operations, liquidity and financial condition. Merchants believes future economic activity will depend on consumer confidence, business expenditures for new capital equipment and personal consumption expenditures. For a description of other factors which could affect Merchants' financial performance and that of its common stock, see "Forward-Looking Statements" at the beginning of this report.
RESULTS OF OPERATIONS
Merchants realized net income of $11.93 million, $11.59 million and $12.62 million for the years ended December 31, 2004, 2003 and 2002, respectively. Basic earnings per share were $1.91, $1.87 and $2.05 and diluted earnings per share were $1.90, $1.86 and $2.02 for the years ended December 31, 2004, 2003 and 2002, respectively. Merchants declared and distributed total dividends of $5.58, $1.04 and $0.96 per share during 2004, 2003 and 2002, respectively. In January 2005, Merchants declared a dividend of $0.27 per share, which was paid on February 17, 2005, to shareholders of record as of February 3, 2005.
Net income as a percentage of average equity capital was 13.81%, 13.75% and 15.73% for 2004, 2003 and 2002, respectively. Net income as a percentage of average assets was 1.17%, 1.28% and 1.54% in 2004, 2003 and 2002, respectively.
Net Interest Income
2004 compared with 2003
Net interest income, on a fully taxable equivalent basis increased $1.93 million to $39.58 million for 2004 from $37.65 million for 2003. Merchants has continued to increase net interest income dollars through balance sheet growth and leverage. At the same time Merchants has experienced decreases in its net interest margin as the spread between the yield on interest earning assets and the cost of interest bearing liabilities has continued to shrink. Merchants' net interest margin decreased 28 basis points to 4.15% from 4.43% over the course of 2004. This decrease was driven by a number of factors. The spread that can be earned between interest earning assets and interest bearing liabilities is dependent to a large extent on the slope of the yield curve. Although the Federal Reserve Board started to raise short-term interest rates during the second half of 2004 the long end of the yield curve moved very little. The spread between the two-year treasury and the ten-year treasury has decreased from approximately 245 basis points at the beginning of 2004 to approximately 119 basis points at the end of the year, a 125 basis point decrease. During 2004 the average rate earned on interest earning assets decreased 40 basis points to 4.97% from 5.37%; at the same time the average rate paid on interest bearing liabilities decreased 14 basis points to .98% from 1.12%. Merchants' has worked to compensate for the margin compression by growing its overall balance sheet; average interest earning assets have increased by $105.06 million for 2004 to $954.43 million from $849.37 million compared to 2003. As shown in the schedule on page 19, increased volumes of interest bearing assets were offset by lower interest rates on those assets, while the cost of increased volumes of interest bearing liabilities was offset by decreases in rates on those liabilities. Merchants' larger base of interest earning assets helped to mitigate the effect of the decrease in the net interest margin, and to protect Merchants' overall net interest income.
Merchants' average loan portfolio increased $45.16 million to $581.26 million from $536.10 million during 2004; however, the average rate on the portfolio decreased 44 basis points over the course of the year. This decrease was driven by repricing of both fixed rate balloon notes and mortgages into lower variable rates. Merchants year-end loan portfolio grew to $584.33 million at December 31, 2004 from $569.00 million at December 31, 2003. The fixed rate portion of the portfolio decreased over the course of the year to $294.66 million from $306.36 million; while variable rate loans increased to $289.67 million from $262.63 million. Over $250 million of the variable rate loans reprice with prime, which will help to offset increased funding costs if rates continue to rise. The repricing of these variable rate loans during the last six months of the year was not enough to offset the overall decline in fixed rate loan yields.
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The average investment portfolio grew by $67.26 million to $372.01 million from $304.75 million; however, Merchants also experienced decreases in the average yield on that portfolio as it decreased 28 basis points to 3.95% for 2004 from 4.23% for 2003. Merchants targets a 2.5 year duration, and generally has no credits rated below an A by the national credit rating services in the portfolio. The low duration of the portfolio, coupled with the slope of the yield curve has slowed growth in margin dollars as rates have risen. Merchants has continued to take advantage of opportunities to use leverage to maximize net interest income. Average short-term borrowings increased $30.31 million to $53.39 million for 2004 from $23.08 million for 2003. As a result of the increase in the federal funds rate, the average cost of short-term borrowings during 2004 increased to 1.43% from 1.09% for 2003. The average cost of short-term borrowings for the fourth quarter of the year was 2.05%. Merchants' average long-term borrowings increased $35.48 million to $41.00 million for 2004 from $5.52 million for 2003. The average cost of those funds decreased during 2004 to 2.43% from 2.92% as Merchants was able to lock in long term lower cost funding in the early part of 2004. Merchants closed its private placement of an aggregate of $20 million of trust preferred securities on December 15, 2004. The securities bear interest for five years at a fixed rate of 5.95%, and after five years, the rate adjusts quarterly at a fixed spread over three month LIBOR. The securities had very little effect on Merchants' results of operations for 2004; Merchants incurred $50 thousand in interest expense related to these securities during December. The impact on net income for 2005 from the additional interest expense, including amortization of the placement fee, is projected to be $826 thousand.
Overall, Merchants' cost of funds has decreased over the course of the year, but not enough to offset the decreases in rates experienced on the asset side. Total average interest bearing liabilities have increased $92.47 million to $803.44 million for 2004 compared to $710.97 million for 2003. The cost of those funds has decreased to .98% for 2004 from 1.12% for 2003. Average interest bearing deposits increased $25.92 million to $708.27 million for 2004 from $682.35 million for 2003. Short-term interest rates remained low for the first six months of the year. The federal funds rate was 1.0% from June 30, 2003 through June 30, 2004. Although short-term rates have moved up 1.25% since June 2004, Merchants' average cost of interest bearing deposits for 2004 was 24 basis points lower than 2003 at .86% compared to 1.10%. Merchants' was able to control deposit costs as short-term rates began to rise in the second half of 2004.
Merchants entered into a $25 million, three year, interest rate swap early in the second quarter of 2002. Merchants received a fixed interest rate and paid prime under the swap. Merchants terminated the swap and received proceeds of $1.3 million during October 2002. This gain on swap termination is being accreted into interest income monthly, using the effective yield method, through April 2005.
2003 compared with 2002
Net interest income, on a fully taxable equivalent basis, increased $270 thousand from 2002 to 2003, in spite of a 43 basis point decrease in the net interest margin. Merchants grew its average interest earning assets $80.48 million, or 10%, to $849.37 million from $768.89 million during 2003. The average loan portfolio increased $56.84 million, or 12%, to $536.10 million from $479.25 million; and the average investment portfolio increased $40.02 million, or 15%, to $304.75 million from $264.73 million during 2003.
The decrease in the net interest margin for 2003 reflects the overall low interest rate environment that began in 2001 and continued throughout 2002 and 2003; interest rates hit historic lows in 2003. During 2003 the average yield on interest earning assets decreased 92 basis points to 5.37 % from 6.29%; at the same time the cost of interest bearing liabilities decreased 60 basis points to 1.12% from 1.72% leading to an overall decrease in interest rate spread of 32 basis points. The average rate earned on Merchants' loan portfolio decreased to 6.07% for 2003 from 7.13% for 2002. As mentioned above, Merchants experienced a 12% increase in its average loan portfolio over the course of 2003, which helped to generate additional interest revenue and mitigate the effect of decreases in loan yields during 2003. The decrease in rates on the overall loan portfolio was driven by several factors. Merchants' year-end residential real estate loan portfolio grew $57 million as borrowers looked to take advantage of historically low interest rates. The average rate on the residential real estate portfolio at December 31, 2003, was 5.60%, a 1.12% decrease from the average rate at the end of 2002 of 6.72%. At the same time, much of the overall growth in the commercial and commercial real estate portfolios was in variable rate products. As a result, more assets were priced at the short end of the yield curve, the lowest point, and further decreased margins. The migration in the commercial and commercial real estate portfolios from fixed rates to lower yielding variable rates that occurred during 2002 continued, although at a slower pace, into 2003; and new commercial originations were primarily in the variable rate category. Variable rate commer-
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cial and commercial real estate loans increased $31.9 million, or 16%, to $231.6 million from $199.7 million during 2003.
The average interest rate earned on the investment portfolio decreased by 99 basis points to 4.23% from 5.22%. As mentioned above, the average investment portfolio grew 15% during 2003. Merchants' average short-term borrowing position increased $21 million over the course of the year, and was $57 million at year-end 2003 as Merchants leveraged its balance sheet to generate additional net interest income.
Over the course of 2003 Merchants' average interest bearing liabilities increased $71.0 million, or 11%, to $711.0 million from $640.0 million. The average rate on all interest bearing liabilities decreased 60 basis points to 1.12% from 1.72% during the year. The average rate paid on savings, NOW and money market deposits decreased 55 basis points and the average rate on time deposits decreased 84 basis points.
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$2.61 million for 2002. The increase in overdraft fee income was due primarily to an overall larger deposit base, as well as general increased overdraft activity. Revenue from monthly service charges on deposits, a component of noninterest income that had been decreasing over the last few years, was flat from 2002 to 2003. The category Other noninterest income increased by $391 thousand from 2002 to 2003. This increase is primarily a result of increases in ATM and debit card fee income, which, net of expenses, increased $220 thousand to $1.21 million for 2003 from $991 thousand for 2002.
Noninterest expense
2004 compared to 2003
Noninterest expense increased $1.31 million to $32.54 million from $31.23 million for 2004 compared to 2003. Merchants' largest noninterest expense category is salaries and wages. This category increased $333 thousand to $11.90 million for 2004 from $11.57 million for 2003, a less than 3% increase. Merchants' average salary increases for 2004 were 5.52%. Merchants continued its incentive compensation program during 2004; the program was primarily focused on overall profitability for 2004, with a component focused on increased sales with a quality control component for the corporate banking division. Incentive compensation increased 5.1% during 2004, and was just under 7% of salaries, consistent with 2003. The 2003 salaries and wages amount includes $266 thousand of dividends paid on shares of stock owned by certain trusts which invest deferred compensation in shares of Merchants' stock. The 2004 salaries and wages amount includes $209 thousand of dividends paid on these shares. Beginning in the fourth quarter of 2004 Merchants no longer expenses these dividends, but instead treats them like any other dividend on common stock, as a charge to retained earnings. This change in dividend treatment reflects Merchants' understanding of current industry practices for these dividends, and also reflects clarified accounting literature related to divided treatment on common stock held by these trusts. Shares held by these trusts are legally outstanding and are considered outstanding for earnings per share purposes. These shares are treated similar to treasury shares for financial reporting purposes. The regular fourth quarter 2004 dividend on these trust shares was $72 thousand; the one-time special dividend paid to these trusts was $1.22 million. These dividends were recorded as a retained earnings charge.
Employee benefit costs increased $257 thousand, or 7.2% to $3.83 million during 2004. The increase was primarily driven by increased costs of group health insurance. Merchants experienced a decrease in its pension plan expense during 2004 as a result of strong returns on plan assets. Occupancy and equipment expenses increased $730 thousand, or 13%, for 2004 compared to 2003, approximately $177 thousand of the year to date increase is attributable to Merchants' two de novo branches, and $290 thousand to Merchants' service center network server infrastructure and desktop computer upgrade completed during 2004. Legal and professional fees were $264 thousand, or 18% higher for 2004 compared to 2003. This increase is primarily a result of increases in investment advisory fees, and additional professional fees related to the service center network upgrade. Marketing expenses decreased to $1.38 million for 2004 from $1.53 million for 2003. This decrease is primarily a result of higher expenses in 2003 related to the opening of two de novo offices and an aggressive 10-year mortgage campaign.
Merchants' equity in losses of Real Estate Limited Partnerships increased $130 thousand, or 8.0%, to $1.75 million during the year as Merchants continued to invest in community based low-income housing partnerships. Merchants accounts for its investment in these partnerships using the equity method. Losses generated by the partnerships are recorded as a reduction in Merchants' investments in the Consolidated Balance Sheets and as an expense in the Consolidated Statements of Operations. Tax credits generated by the partnerships are recorded as a reduction in the income tax provision. Merchants finds these investments attractive because they provide a targeted internal rate of return of approximately 12%, and provide an opportunity to invest in affordable housing in the communities in which Merchants does business. Other noninterest expenses decreased $382 thousand, or 7.2% to $4.9 million during 2004. There were a number of small decreases that led to this overall decrease.
2003 compared to 2002
Noninterest expense increased $1.74 million to $31.23 million for 2003 compared to $29.50 million for 2002, a 5.88% increase. Salaries and Wages increased $238 thousand to $11.57 million for 2003 compared to 2002, a 2.1% increase. Merchants' average salary increases for 2003 were just under 6%. Merchants continued its incentive program during 2003. The program for 2003 focused entirely on profitability for Service Center staff, and on increased sales with a quality control component in the branches and corporate banking division. Incentive compensation decreased almost
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Merchants continued to work with its investment advisory firm hired in early 2003. The firm is a registered investment advisor specializing in stable value and fixed income portfolios, and has a staff of investment professionals who research and track each bond. As of December 31, 2004 the firm had over $44 billion in assets under management. During the year, Merchants increased the investment portfolio (excluding trading securities) $37.0 million, or 10.9% to $376.55 million. Average investments increased to $372.00 million from $304.75 million during 2004. At the same time Merchants increased its average combined Other Short-term Borrowings and Long-term Debt $65.8 million to $93.62 million from $27.77 million. Combined year-end balances in these borrowing categories were $104.76 million. As mentioned in the earlier discussion on net interest income, this leverage has helped Merchants mitigate the effect of 2004's margin compression on its net interest income during the year.
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these loans each quarter and determines or confirms the appropriate risk rating and accrual status. The findings of this review process are instrumental in determining the adequacy of the allowance for loan losses.
Discussion of 2004 Events Affecting Nonperforming Assets
Historically, Merchants has worked closely with borrowers to collect obligations and when necessary pursued more vigorous collection efforts. Merchants' Credit Department and Commercial Loan Officers work together to address collection strategies for nonperforming assets. The following schedule shows the components of nonperforming assets as of the end of each of the previous five quarters:
Nonaccrual Loans
Nonaccrual loans increased to $3.23 million at December 31, 2004 from $2.10 million at December 31, 2003. During 2004 management identified $4.1 million in new nonperforming loans. Based on continued performance approximately $400 thousand in nonaccrual loans were returned to accrual status, principal payments of approximately $1.8 million were collected and approximately $730 thousand of nonaccrual loans were charged off. The large year over year increase in non performing loans can be attributed primarily to a single customer in the food processing industry that was placed in non-accrual during the third quarter of 2004. This company continues to operate and is attempting to recapitalize. Collateral for this relationship consists primarily of real estate and equipment.
Loans Past Due 90 Days or More and Still Accruing Interest
Merchants generally places loans that become 90 or more days past due in nonaccrual status; if, in the opinion of management, the ultimate collectibility of principal and interest is assured, loans may continue to accrue interest and be left in this category. Included in this category are loans which have reached maturity and have not been renewed on a timely basis, for reasons other than financial capacity to pay.
Restructured Loans
Restructured loans decreased slightly from $86 thousand at December 31, 2003 to $83 thousand at December 31, 2004.
Other Real Estate Owned
Merchants aggressively markets OREO. The balance of OREO was zero at December 31, 2003 and December 31, 2004.
Policies and Procedures Related to the Accrual of Interest Income
Merchants recognizes income on earning assets on an accrual basis, which calls for the recognition of income as earned, rather than when it is collected. Merchants' policy is to classify a loan 90 days or more past due with respect to principal or interest as a nonaccruing loan, unless the ultimate collectibility of principal and interest is assured. Income accruals are suspended on all nonaccruing loans, and all previously accrued and uncollected interest is typically charged against current income. A loan remains in nonaccruing status until the factors which suggest doubtful collectibility no longer exist, the loan is liquidated, or when the loan is determined to be uncollectible, and is charged off against the allowance for loan losses. In those cases where a nonaccruing loan is secured by real estate, Merchants can, and may, initiate foreclosure proceedings. The result of such action will either be to cause repayment of the loan with the proceeds of a foreclosure sale or to give Merchants possession of the collateral in order to manage a future resale of the real estate. Foreclosed property is recorded at the lower of its cost or estimated fair value, less any estimated costs to sell. Any cost in excess of the estimated fair value on the transfer date is charged to the Allowance, while further declines in market values are recorded as OREO expense in the statement of operations.
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Loan Portfolio Monitoring
Merchants' Board of Directors grants each loan officer the authority to originate loans on behalf of Merchants, subject to certain limitations. The Board of Directors also establishes restrictions regarding the types of loans that may be granted and the distribution of loan types within Merchants' portfolio, and sets loan authority limits for each lender. These authorized lending limits are reviewed at least annually and are based upon the lender's knowledge and experience. Loan requests that exceed a lender's authority require the signature of Merchants' credit division manager, senior loan officer, and/or Merchants' President. All extensions of credit of $2.5 million or greater to any one borrower, or related party interest, are reviewed and approved by the Loan Committee of Merchants' Board of Directors.
The Directors Loan Committee and the credit department regularly monitor Merchants' loan portfolio. The entire loan portfolio as well as individual loans is reviewed for loan performance, creditworthiness, and strength of documentation. Merchants monitors loan concentrations by individual borrowers, industries and loan types. As part of the annual credit policy review process, targets are set by loan type for the total portfolio. Merchants has hired external loan review firms to assist in monitoring both the commercial and residential loan portfolios. During 2004 the commercial loan review firm performed three comprehensive reviews of Merchants' loan portfolio, and reviewed approximately 75% (in dollar volume) of Merchants' commercial loan portfolio. Credit risk ratings are assigned to commercial loans at origination and are routinely reviewed by both management and the external loan review firms.
All loan officers are required to service their loan portfolios and account relationships. As necessary, loan officers or the credit department personnel take remedial actions to assure full and timely payment of loan balances.
Allowance for Loan Losses
The Allowance is based on Management's estimate of the amount required to reflect the known and inherent risks in the loan portfolio, based on circumstances and conditions known at each reporting date. Merchants reviews the adequacy of the Allowance quarterly. Factors considered in evaluating the adequacy of the Allowance include previous loss experience, the size and composition of the portfolio, risk rating composition, current economic and real estate market conditions and their effect on the borrowers, the performance of individual loans in relation to contract terms and estimated fair values of properties that secure impaired loans.
The adequacy of the Allowance is determined using a consistent, systematic methodology, consisting of a review of the following key elements:
*
A specific reserve for loans identified as impaired;
*
A general reserve for the various loan portfolio classifications;
*
The unallocated Allowance for loan losses
Loans considered for impairment totaled $3.8 million and $2.7 million and the related specific allocation of the Allowance was $72 thousand and $22 thousand at December 31, 2004 and 2003, respectively.
Loans considered for impairment consist of the following:
*
Nonaccrual loans with balances over $50 thousand;
*
Restructured loans;
*
Loans past due over 60 days;
*
Certain internally adversely classified loans which are 30 days past due; and
*
Loans which have been assigned a specific allocation of the Allowance
Merchants performs detailed and extensive reviews on these loans and on larger credits and problematic credits identified on the watched asset list, nonperforming asset listings and internal credit rating reports. Through these reviews Merchants is able to determine if a loan requires a specific allocation of the Allowance or is permanently impaired and needs to be charged down. Loans are evaluated by looking at the fair market value of the collateral, if the loan is collateral dependent; or measuring the net present value of the expected future cash flows using the loan's original effective interest rate. If the loan is impaired further analysis is performed to determine if the impairment is permanent. If the impairment is deemed permanent the loan is charged down to its net realizable value through the Allowance.
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The general Allowance is a percentage-based reflection of historical loss experience and assigns a required Allowance allocation by loan classification based on a fixed percentage of all outstanding loan balances. The general Allowance employs a risk-rating model that grades loans based on their general characteristics of credit quality and relative risk. For pass rated loans, appropriate Allowance levels are estimated based on judgments regarding the historical loss experience, current economic trends, trends in the portfolio mix, volume and trends in delinquencies and non-accrual loans and off-balance sheet credit risk. As of December 31, 2004, the Allowance related to pass rated loans was $3.3 million. For loans rated special mention or substandard, the Allowance allocation is increased; as of December 31, 2004, the Allowance related to special mention or substandard loans was $1.7 million.
In addition to the specific and general components, there is an unallocated Allowance that recognizes a measurement imprecision in the valuation and general components of the allowance and Management's evaluation of various other conditions not measured in the specific and general components, including the following:
*
general economic and business conditions affecting Merchants' key lending areas;
*
credit quality trends;
*
loan volumes and concentrations;
*
specific industry conditions within portfolio segments
As of December 31, 2004, the unallocated Allowance was $2.0 million, an increase from $901 thousand at December 31, 2003. The increase in the unallocated Allowance is primarily attributable to the decline in criticized/classified loans during the year. These loans have a higher reserve requirement than the rest of the loan portfolio.
Losses are charged against the Allowance when management believes that the collectibility of principal is doubtful. To the extent management determines the level of anticipated losses in the portfolio has significantly increased or diminished, the Allowance is adjusted through current earnings. Overall, management believes that the Allowance is maintained at an adequate level, in light of historical and current factors, to reflect the level of credit risk in the loan portfolio. Loan loss experience and nonperforming asset data are presented and discussed in relation to their impact on the adequacy of the Allowance.
The following table reflects Merchants
' loan loss experience and activity in the Allowance for the past five years.
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As of December 31, 2004, Merchants' Allowance ratios were 225% of nonperforming loans and 1.29% of total loans. Although the Allowance has declined over the past five years both in size and as a percentage of the loan portfolio, management has not added to the Allowance for several reasons; most notable is the shift in the composition of the loan portfolio over the last five years, on a percentage basis, from higher risk commercial asset classes to less risky residential categories, as shown in the table on page 23. In addition, the previously described increase in the unallocated Allowance indicates the Allowance was adequate at December 31, 2004.
Merchants will continue to take all appropriate measures to restore nonperforming assets to performing status or otherwise liquidate these assets in an orderly fashion so as to maximize their value to Merchants. There can be no assurances that Merchants will be able to complete the disposition of nonperforming assets without incurring further losses.
RELATED PARTY TRANSACTIONS
Merchants engages in banking transactions with certain of its directors and officers, and certain of their affiliates. During 2004 Merchants obtained legal services from a firm associated with one of its directors totaling $37 thousand; and project management services from a firm associated with one of its directors totaling $106 thousand. Merchants obtained insurance during 2004 through an insurance agency ("Agency") of which a director of Merchants Bank is president. A director of Merchants is also a director of one of the insurance companies through which the Agency obtained insurance for Merchants. In 2004, premiums paid to the Agency totaled $177 thousand, of which the insurance company received $9 thousand. Merchants obtains these services on terms that are comparable to those that it would obtain from unaffiliated third parties.
At December 31, 2004, Merchants had loans outstanding to directors, executive officers, and associates of such persons totaling $3.72 million. It is the policy of Merchants to make these loans on substantially the same terms, including interest rates and collateral, as those prevailing for comparable lending transactions with other persons. As of December 31, 2004, all loans to directors, officers, and certain of their affiliates, were performing in accordance with their contractual terms.
EFFECTS OF INFLATION
The financial nature of Merchants' consolidated balance sheet and statement of operations is more clearly affected by changes in interest rates than by inflation, but inflation does affect Merchants because as prices increase the money supply tends to increase, the size of loans requested tends to increase, total company assets increase, and interest rates are affected by inflationary expectations. In addition, operating expenses tend to increase without a corresponding increase in productivity. There is no precise method, however, to measure the effects of inflation on Merchants' financial statements. Accordingly, any examination or analysis of the financial statements should take into consideration the possible effects of inflation.
RECENT ACCOUNTING PRONOUNCEMENTS
In November 2003, the Emerging Issues Task Force ("EITF") issued issue summary 03-1 ("EITF 03-1"), Meaning of Other Than Temporary Impairment and its application to Certain Investments. EITF 03-01 addressed an entity's treatment of the impairment of securities when such an impairment is considered other than temporary. The preliminary summary required disclosures only related to other than temporary impairment. In March 2004, the EITF continued its discussion and reached a consensus on the procedures for recognizing an impairment of securities considered other than temporarily impaired. The guidance in EITF 03-1 was intended to be effective for reporting periods beginning after June 15, 2004. However in September 2004, the FASB issued FSP EITF 03-1-1 which delayed the effective date for the measurement and recognition provisions of EITF 03-1 until further implementation guidance could be established. This delay does not suspend the requirement to recognize other-than-temporary impairments as required by existing authoritative literature. Based on the composition of the investment portfolio held at December 31, 2004, EITF 03-1 is not expected to have a material effect on the Merchants' financial position or results of operations.
In December 2003 the FASB issued SFAS No. 132 (revised), "Employers' Disclosures about Pensions and Other Postretirement Benefits." SFAS No. 132 (revised) prescribes employers' disclosures about pension plans and other
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postretirement benefit plans, but it does not change the measurement or recognition of those plans. The statement retains and revises the disclosure requirements contained in the original SFAS No. 132. It also requires additional disclosures about the assets, obligations, cash flows, and net periodic benefit costs of defined benefit pension plans and other postretirement benefit plans. SFAS No. 132 (revised) generally was effective for fiscal years ending after December 15, 2003. Merchants' disclosures incorporate the revised disclosure requirements.
In December 2003 the FASB issued Interpretation No. 46 (revised), "Consolidation of Variable Interest Entities" ("FIN 46R"), which addresses how a business enterprise should evaluate whether it has a controlling financial interest in an entity through means other than voting rights and, accordingly, should consolidate the variable interest entity ("VIE"). FIN 46R replaces FIN 46 that was issued in January 2003. Merchants is required to apply FIN 46R to variable interests generally as of March 31, 2004 and to special-purpose entities as of December 31, 2003. For any VIE's that must be consolidated under FIN 46R that were created before January 1, 2004, the assets, liabilities and non-controlling interest of the VIE initially would be measured at their carrying amounts, and any difference between the net amount added to the balance sheet and any previously recognized interest would be recorded as a cumulative effect of an accounting change. If determining the carrying amounts is not practicable, fair value at the date FIN No. 46R first applies may be used to measure the assets, liabilities and non-controlling interest of the VIE. The requirements of FIN 46R resulted in the deconsolidation of the Company's wholly owned subsidiary trust, formed to issue mandatorily redeemable preferred securities ("trust preferred securities"). The deconsolidation, as of December 31, 2004, results in the derecognition of the $20.0 million of trust preferred securities and the recognition of junior subordinated debentures of $20.62 million and investment in the subsidiary trust of $619 thousand in Merchants' 2004 consolidated statement of financial position.
In December 2004, the FASB issued revised statement No. 123 ("FAS 123R"), "Share-Based Payment", which requires companies to expense the estimated fair value of employee stock options and similar awards. The accounting provisions of FAS 123R will be effective for public companies beginning July 1, 2005. Merchants will adopt the provisions of FAS 123R using a modified prospective application. Under the modified prospective application, FAS 123R, which provides certain changes to the method for valuing stock-based compensation among other changes, will apply to new awards and to awards that are outstanding on the effective date and are subsequently modified or cancelled. Compensation expense for outstanding awards for which the requisite service has not been rendered as of the effective date will be recognized over the remaining service period using the compensation cost calculated for pro forma disclosure purposes under FAS 123. Merchants is in the process of determining how the new method of valuing stock-based compensation as prescribed in FAS 123R will be applied to valuing stock-based awards granted after the effective date and the impact the recognition of compensation expense related to such awards will have on Merchants' financial statements.
LIQUIDITY AND CAPITAL RESOURCE MANAGEMENT
General
Liquidity, as it pertains to banking, can be defined as the ability to meet cash commitments at all times in the most economical way to satisfy loan and deposit withdrawal demand, and to meet other business opportunities that require cash. Sources of liquidity for banks include short-term liquid assets, cash generated from loan repayments and amortization, borrowing, deposit generation and earnings. Merchants has a number of sources of liquid funds, including $28 million in available Federal Funds lines of credit with correspondent banks at year-end 2004; an overnight line of credit with the FHLB of $15 million; an estimated additional borrowing capacity with the FHLB of $50 million; and the ability to borrow through the use of repurchase agreements, collateralized by Merchants' investments, with certain approved counterparties. Merchants' investment portfolio, which totaled $377 million at December 31, 2004, is actively managed by the Merchants' Asset Liability Committee ("ALCO") and is a strong source of cash flow for Merchants. The portfolio is fairly liquid, with a weighted average life of approximately 2.8 years, and is available to be used as a source of funds, if needed.
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Contractual Obligations
Merchants has certain long-term contractual obligations; including long-term debt agreements, operating leases for branch operations, and time deposits. The maturity schedules for these obligations are as follows:
(In thousands)
Less than
One Year
One Year
To Three
Years
Three
Years To
Five Years
Over Five
Years
Total
Debt Maturities
$ 29,243
$18,085
$ 522
$ 1,907
$ 49,757
Junior Subordinated Debentures
--
--
--
20,000
20,000
Operating Lease Payments
1,311
3,414
Time Deposits
136,973
35,882
21,691
194,586
$166,736
$54,910
$22,853
$23,258
$267,757
Commitments and Off-Balance Sheet Risk
Merchants is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments primarily include commitments to extend credit and financial guarantees. Such instruments involve, to varying degrees, elements of credit and interest rate risk that are not recognized in the accompanying Consolidated Balance Sheets.
Exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and financial guarantees written is represented by the contractual amount of those instruments. Merchants uses the same credit policies in making commitments as it does for on-balance sheet instruments. The contractual amounts of these financial instruments at December 31, 2004, are as follows:
(In thousands)
Contractual Amount
Financial Instruments Whose Contract Amounts
Represent Credit Risk:
Co mmitments to Originate Loans
$ 28,155
Unused Lines of Credit
103,273
Standby Letters of Credit
8,746
Equity Commitments to Affordable Housing
Limited Partnerships
4,851
Commitments to originate loans are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments to originate loans generally have expiration dates within 60 days of the commitment. Unused lines of credit have expiration dates ranging from one to two years from the date of the commitment. Since a portion of the commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent a future cash requirement. Merchants evaluates each customer's creditworthiness on a case-by-case basis. Upon extension of credit Merchants obtains an appropriate amount of real and/or personal property as collateral based on management's credit evaluation of the counterparty.
FASB Interpretation No. 45 ("FIN No. 45"), "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others; an Interpretation of FASB Statements No. 5, 57, and 107, and rescission of FASB Interpretation No. 34," requires certain disclosures and liability-recognition for the fair value at issuance of guarantees that fall within its scope. Under FIN No. 45, Merchants does not issue any guarantees that would require liability-recognition or disclosure, other than its standby letters of credit. Merchants has issued conditional commitments in the form of standby letters of credit to guarantee payment on behalf of a customer and guarantee the performance of a customer to a third party. Standby letters of credit generally arise in connection with lending relationships. The credit risk involved in issuing these instruments is essentially the same as that involved in extending loans to customers. Contingent obligations under standby letters of credit totaled approximately $8.7 million and $7.0 million at December 31, 2004 and 2003, respectively and represent the maximum potential future payments Merchants could be required to make. Typically, these instruments have terms of 12 months or less and expire unused; therefore, the total amounts do not necessarily represent future cash requirements. Each customer is evaluated individually for creditworthiness under the same underwriting standards used for commitments to extend credit and on-balance sheet
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ITEM 7A
ITEM 7A - -QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
RISK MANAGEMENT
General
Management and the Board of Directors of Merchants are committed to sound risk management practices throughout the organization. Merchants has developed and implemented a centralized risk management monitoring program. Risks associated with Merchants' business activities and products are identified and measured as to probability of occurrence and impact on Merchants (low, moderate, or high), and the control or other activities in place to manage those risks are identified and assessed. Periodically, department-level and senior managers re-evaluate and report on the risk management processes for which they are responsible. This documented program provides management with a comprehensive framework for monitoring Merchants' risk profile from a macro perspective; it also serves as a tool for assessing internal controls over financial reporting as required under the FDICIA and the Sarbanes-Oxley Act of 2002.
Market Risk
Market risk is the risk of loss in a financial instrument arising from adverse changes in market rates/prices such as interest rates, foreign currency exchange rates, commodity prices, and equity prices. Merchants' primary market risk exposure is interest rate risk. An important component of Merchants' asset and liability management process is the ongoing monitoring and management of this risk, which is governed by established policies that are reviewed and approved annually by Merchants' Board of Directors. The Investment policy details the types of securities that may be purchased, and establishes portfolio limits and maturity limits for the various sectors. The Investment policy also establishes specific investment quality limits. The Board of Directors delegates responsibility for carrying out the asset/liability management policies to the ALCO. In this capacity the ALCO develops guidelines and strategies impacting Merchants' asset and liability management related activities based upon estimated market risk sensitivity, policy limits and overall market interest rate levels and trends. The ALCO manages the investment portfolio. As the portfolio has grown, the ALCO has used portfolio diversification as a way to mitigate the risk of being too heavily invested in any single asset class. Merchants continued to work to maximize net interest income while mitigating risk during 2004 through further repositioning of the investment portfolio, as well as carefully monitoring the overall duration and average life of the portfolio, as well as monitoring individual securities, among other strategies. Merchants has an outside investment advisory firm which helps it identify opportunities for increased yield, without significantly increasing risk, in the investment portfolio. The firm specializes in stable value and fixed income portfolios, and has a staff of investment professionals
who research and track each bond. The ALCO has a weekly conference call with the investment advisor. During these calls the ALCO and the investment advisor discuss trading activity from the previous week, and set strategy for the ensuing week. Additionally, any specific bonds or sectors that require additional attention are discussed on these calls. The investment advisory firm meets with the ALCO committee of Merchants' Board of Directors to perform a portfolio review on a quarterly basis. They report on the overall performance of the portfolio and perform modeling of the cash flow, effective duration, and yield characteristics of the portfolio under various interest rate scenarios. The investment advisors also review and provide detail on individual holdings in the portfolio. During the course of the last year, Merchants' position in Commercial Mortgage Backed Securities ("CMBS") has increased to $67.30 million. Management feels that opportunities for increased yield, without taking on undue risk, exist in the CMBS market. The goal is to enhance performance on an absolute and risk-adjusted basis. During the first quarter of the year Merchants reduced its exposure to Asset Backed Securities ("ABS") from approximately $48 million to $17 million as a result of a detailed evaluation of the ABS sector of the portfolio. In most instances the sale of the bonds eliminated or reduced exposure to a specific market segment, or to a specific servicer.
Interest Rate Risk
Interest rate risk is the exposure to a movement in interest rates, which, as described above, affects the Company's net interest income. Asset/liability management is governed by policies reviewed and approved annually by the Board of Directors. The ALCO, chaired by the Chief Financial Officer and composed of members of senior management, meets frequently to review and develop asset/liability management strategies and tactics.
The ALCO is responsible for evaluating and managing the interest rate risk which arises naturally from imbalances in repricing, maturity and cash flow characteristics of Merchants' assets and liabilities. Techniques used by the ALCO take into consideration the cash flow and repricing attributes of balance sheet and off-balance sheet items and their
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relation to possible changes in interest rates. The ALCO manages its interest rate exposure primarily by using on-balance sheet strategies, generally accomplished through the management of the duration, rate sensitivity and average lives of the Company's various investments, and by extending or shortening maturities of borrowed funds, as well as carefully managing and monitoring the pricing of loans and deposits. The ALCO also uses off-balance sheet strategies, such as interest rate caps and floors and interest rate swaps, to help minimize the Company's exposure to changes in interest rates. The ALCO uses an outside investment advisor to recommend investments and assist in transaction execution, and an outside ALCO consultant to perform rate shocks of its balance sheet and a variety of other analyses for the Committee. The ALCO is responsible for ensuring that the Board of Directors receives accurate information regarding Merchants' interest rate risk position at least quarterly. The investment advisor and ALCO consultant meet jointly with the ALCO and the Asset/Liability Committee of the Board of Directors on a quarterly basis to review current position and discuss future strategies. This review shows that Merchants' one year gap position has changed very little over the last year. At December 31, 2004 Merchants' one year gap position was a $29.2 million liability sensitive position, compared to a $30.6 million liability sensitive position at the end of 2003.
Merchants has established a target range for the change in net interest income, given a 200 basis point change in interest rates, of zero to 7.5%. The net interest income simulation as of December 31st showed that the change in net interest income for the next 12 months from Merchants' expected or "most likely" forecast was as follows:
Rate Change
Percent Change in
Net Interest Income
Up 200 basis points
(0.3%)
Down 200 basis points
(5.6%)
The analysis shows additional margin compression in both the up and down 200 basis points scenarios. The ability to reduce funding costs is limited in the falling rate environment, while the approximately $250 million base of variable-rate prime based loans rapidly reset to lower yields. If rates fall further it will be difficult for Merchants to lower deposit rates enough to compensate for these anticipated decreases in loan rates. In a rising rate scenario, market rate increases affect the liability base faster than the asset side of the balance sheet. The model shows that after deposit costs begin to stabilize, margins begin to widen and net interest income increases. The degree to which this exposure materializes will depend, in part, on Merchants' ability to manage deposit and loan rates as interest rates rise or fall.
The analysis discussed above includes no growth assumptions. The consultant also generally runs additional simulations, modeling a 200 and 400 basis point upward movement in rates with a flattening yield curve, and a simulation using Merchants' current growth assumptions. The flattening yield curve scenario resulted in a slight increase in net interest income in the first year, additional margin compression in year two and increases in years three through five. These types of dynamic analyses give the ALCO a more thorough understanding of how Merchants' balance sheet will perform in a variety of rate environments.
The preceding sensitivity analysis does not represent Merchants' forecast and should not be relied upon as being indicative of expected operating results. These estimates are based upon numerous assumptions including without limitation: the nature and timing of interest rate levels including yield curve shape, prepayments on loans and securities, deposit run-off rates, pricing decisions on loans and deposits and reinvestment/replacement of asset and liability cash flows, among others. While assumptions are developed based upon current economic and local market conditions, Merchants cannot make any assurances as to the predictive nature of these assumptions including how customer preferences or competitor influences might change.
The most significant factors affecting market risk exposure of net interest income during the year ended December 31, 2004 were (i) the shape and level of the U.S. Government securities and interest rate swap yield curve, (ii) changes in the size and composition of the investment portfolio, (iii) changes in the composition and size of the loan portfolio, and (iv) reduction of deposit interest expense. During 2004 the yield curve flattened significantly as rates on two year treasuries increased approximately 118 basis points while rates on ten year treasuries decreased approximately eight basis points, and rates on the long bond decreased 17 basis points.
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Based on historical experience and Merchants' internal repricing policies, it is Merchants' practice to present repricing of statement savings, savings deposits, Free Checking for Life® and NOW account balances in the "One Year to Five Years" category. Merchants' experience has shown that the rates on these deposits tend to be less rate-sensitive than other types of deposits.
Credit Risk
The Board of Directors reviews and approves Merchants' loan policy on an annual basis. Among other things, the loan policy establishes restrictions regarding the types of loans that may be granted, and the distribution of loan types within Merchants' portfolio. Merchants' Board of Directors grants each loan officer the authority to originate loans on behalf of Merchants, subject to certain limitations. These authorized lending limits are reviewed at least annually and are based upon the lender's knowledge and experience. Loan requests that exceed a lender's authority require the signature of Merchants' credit division manager, senior loan officer, and/or president. All extensions of credit of $2.5 million or greater to any one borrower or related party interest, are reviewed and approved by the Loan Committee of Merchants' Board of Directors. Merchants' loan portfolio is continuously monitored for performance, creditworthiness and strength of documentation through the use of a variety of management reports and with the assistance of an external loan review firm. Credit ratings are assigned to commercial loans and are routinely reviewed. Loan officers or the loan workout function take remedial actions to assure full and timely payment of loan balances when necessary. Merchants' policy is to discontinue the accrual of interest on loans when scheduled payments become contractually past due 90 or more days and the ultimate collectibility of principal or interest becomes doubtful.
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Merchants Bancshares, Inc.
Consolidated Statements of Changes in Shareholders' Equity
For the Years Ended December 31, 2004, 2003, and 2002
See accompanying notes to the consolidated financial statements.
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Merchants Bancshares, Inc.
Notes to Consolidated Financial Statements
December 31, 2004, 2003 and 2002
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of Merchants Bancshares, Inc. and its wholly owned subsidiaries Merchants Bank, Merchants Properties, Inc. as well as Merchants Bank's wholly owned subsidiary Merchants Trust Company (collectively "Merchants"). All material intercompany accounts and transactions are eliminated in consolidation. Merchants Bank and Merchants Trust Company offer a full range of deposit, loan, cash management, and trust services to meet the financial needs of individual consumers, businesses and municipalities at 35 full-service banking locations throughout the state of Vermont.
Management's Use of Estimates in Preparation of Financial Statements
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of income and expenses during the reporting periods. The most significant estimates include those used in determining the allowance for loan losses, income taxes, and interest income recognition on loans. Operating results in the future may vary from the amounts derived from management's estimates and assumptions.
Cash and Cash Equivalents
Cash and cash equivalents consist of cash on hand and amounts due from banks in the accompanying consolidated statements of cash flows.
Investment Securities
Merchants classifies certain of its investments in debt securities as held to maturity, which are carried at amortized cost if Merchants has the positive intent and ability to hold such securities to maturity. Investments in debt securities that are not classified as held to maturity and equity securities that have readily determinable fair values are classified as available for sale securities or trading securities. Trading securities are investments purchased and held principally for the purpose of selling in the near term; available for sale securities are investments not classified as trading or held to maturity. Available for sale securities are carried at fair value which is measured at each reporting date. The resulting unrealized gain or loss is reflected in accumulated other comprehensive income (loss) net of the associated tax effects. Trading securities are also carried at fair value; gains and losses are recognized through the statements of operations. Gains and losses on sales of investment securities are recognized through the statement of operations using the specific identification method.
Transfers from securities available for sale to securities held to maturity are recorded at the securities' fair values on the date of the transfer. Any net unrealized gains or losses continue to be reported as a separate component of shareholders' equity, on a net of tax basis. As long as the securities are carried in the held to maturity portfolio, such amounts are amortized over the estimated remaining life of the transferred securities as an adjustment to yield in a manner consistent with the amortization of premiums and discounts. Net amortization of such amounts totaled $24 thousand and $15 thousand in 2004 and 2003, respectively.
Interest and dividend income, including amortization of premiums and discounts, is recorded in earnings for all categories of investment securities. Discounts and premiums related to debt securities are amortized using a method which approximates the level-yield method. The gain or loss recognized on the sale of an investment security is based upon the adjusted cost of the specific security.
Management reviews reductions in fair value below book value of investment securities to determine whether the impairment is other than temporary. If the impairment is determined to be other than temporary in nature, the carrying value of the security is written down to the appropriate level by a charge to earnings in the period of determination.
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Federal Home Loan Bank Stock
As a member of the Federal Home Loan Bank of Boston ("FHLB"), Merchants is required to hold stock in the FHLB. FHLB stock is carried at cost since there is no readily available market value. The stock cannot be sold, but can be redeemed by the FHLB at cost.
Loans
Loans are carried at the principal amounts outstanding net of the allowance for loan losses, and net of deferred loan costs and fees. Deferred loan costs and fees are amortized over the estimated lives of the loans using the interest method.
Allowance for Loan Losses
The Allowance for Loan Losses ("Allowance") is based on management's estimate of the amount required to reflect the known and inherent risks in the loan portfolio. The Allowance is based on management's systematic periodic review of the collectibility of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower's ability to repay, estimated value of any underlying collateral and prevailing economic conditions.
In addition, Federal regulatory agencies, as an integral part of their examination process, periodically review Merchants' Allowance and may require Merchants to recognize additions to the Allowance based on their judgments about information available to them at the time of their examination, which may not be currently available to management.
Factors considered in evaluating the adequacy of the Allowance include previous loss experience, the size and composition of the portfolio, current economic and real estate market conditions and their effect on the borrowers, the performance of individual loans in relation to contract terms, and estimated fair market values of collateral properties.
A loan is considered impaired, based on current information and events, if it is probable that Merchants will be unable to collect the scheduled payments of principal or interest when due, according to the contractual terms of the loan agreement. Impairment on collateral-dependent loans, which comprise a significant majority of Merchants' loan portfolio, is measured based on the fair value of collateral. Unsecured loans are measured for impairment based on expected future cash flows, discounted at the historical effective interest rate. Loans continue to be classified as impaired unless they are brought fully current and the collection of scheduled interest and principal is considered probable.
Income Recognition on Impaired and Nonaccrual Loans
Loans, including impaired loans, are generally classified as nonaccrual if they are past due as to maturity or payment of principal or interest for a period of more than 90 days, unless such loans are well-collateralized and in the process of collection. If a loan or a portion of a loan is internally classified as doubtful or is partially charged-off, the loan is classified as nonaccrual. Loans that are on a current payment status or past due less than 90 days may also be classified as nonaccrual if repayment in full of principal and/or interest is in doubt.
Loans may be returned to accrual status when all principal and interest amounts contractually due (including arrearages) are reasonably assured of repayment within an acceptable period of time, and there is a sustained period of repayment performance (generally a minimum of six months) by the borrower, in accordance with the contractual terms of the loans.
While a loan is classified as nonaccrual and the future collectibility of the recorded loan balance is uncertain, any payments received are generally applied to reduce the principal balance. When the future collectibility of the recorded loan balance is expected, interest income may be recognized on a cash basis. In the case where a nonaccrual loan had been partially charged-off, recognition of interest on a cash basis is limited to that which would have been recognized on the recorded loan balance at the contractual interest rate. Interest collections in excess of that amount are recorded as recoveries to the Allowance until prior charge-offs have been fully recovered.
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Premises and Equipment
Premises and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation and amortization are provided using straight-line and accelerated methods at rates that depreciate the original cost of the premises and equipment over their estimated useful lives. Expenditures for maintenance, repairs and renewals of minor items are generally charged to expense as incurred. When premises and equipment are replaced, retired, or deemed no longer useful they are written down to estimated selling price less costs to sell by a charge to current earnings.
Gains and Losses on Sales of Loans
Gains and losses on sales of loans are recognized based upon the difference between the selling price and the carrying amount of loans sold. Gains and losses are adjusted for servicing rights resulting from the sale of certain loans with servicing rights retained. Deferred loan costs and fees are recognized in income at the time such loans are sold.
Income Taxes
Deferred tax assets and liabilities are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. Low-income housing tax credits and historic rehabilitation credits are recognized as a reduction of income tax expense in the year in which they are earned.
Investments in Real Estate Limited Partnerships
Merchants has investments in various real estate limited partnerships that acquire, develop, own and operate low and moderate-income housing. Merchants' ownership interest in these limited partnerships ranges from 3.3% to 99% as of December 31, 2004. Merchants accounts for its investments in limited partnerships, where Merchants neither actively participates nor has a controlling interest, under the equity method of accounting. Merchants consolidates the financial statements of the only limited partnership in which it is the general partner, actively involved in management, and has a controlling interest.
Management periodically reviews the results of operations of the various real estate limited partnerships to determine if the partnerships generate sufficient operating cash flow to fund their current obligations. In addition, management reviews the current value of the underlying property compared to the outstanding debt obligations. If it is determined that the investment suffers from a permanent impairment, the carrying value is written down to the estimated realizable value. The maximum exposure on these investments is the current carrying amount plus amounts funded in the future.
Other Real Estate Owned
Collateral acquired through foreclosure is recorded at the lower of cost or fair value, less estimated costs to sell, at the time of acquisition. Subsequent decreases in the fair value of other real estate owned ("OREO") are reflected as a write-down and charged to expense. Net operating income or expense related to foreclosed property is included in noninterest expense in the accompanying consolidated statements of operations. There are inherent uncertainties in the assumptions with respect to the estimated fair value of other real estate owned. Because of these inherent uncertainties, the amount ultimately realized on OREO may differ from the amounts reflected in the consolidated financial statements.
Recent Accounting Pronouncements
In November 2003, the Emerging Issues Task Force ("EITF") issued issue summary 03-1 ("EITF 03-1"), "Meaning of Other Than Temporary Impairment and its application to Certain Investments." EITF 03-01 addressed an entity's treatment of the impairment of securities when such impairment is considered other than temporary. The preliminary summary required disclosures only related to other than temporary impairment. In March 2004, the EITF continued its discussion and reached a consensus on the procedures for recognizing an impairment of securities considered other than temporarily impaired. The guidance in EITF 03-1 was intended to be effective for reporting periods beginning after June 15, 2004. However in September 2004, the FASB issued FSP EITF 03-1-1 which delayed the effective date for the measurement and recognition provisions of EITF 03-1 until further implementation guidance could be established. This delay does not suspend the requirement to recognize other-than-temporary impairments as required by existing authoritative literature. Based on the composition of the investment portfolio held at December 31, 2004, EITF 03-1 is not expected to have a material effect on the Company's financial position or results of operations.
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In December 2003 the FASB issued SFAS No. 132 (revised), "Employers' Disclosures about Pensions and Other Postretirement Benefits." SFAS No. 132 (revised) prescribes employers' disclosures about pension plans and other postretirement benefit plans, but it does not change the measurement or recognition of those plans. The statement retains and revises the disclosure requirements contained in the original SFAS No. 132. It also requires additional disclosures about the assets, obligations, cash flows, and net periodic benefit costs of defined benefit pension plans and other postretirement benefit plans. SFAS No. 132 (revised) generally was effective for fiscal years ending after December 15, 2003. Merchants' disclosures in Note 10 incorporate the revised disclosure requirements.
In December 2003 the FASB issued Interpretation No. 46 (revised), "Consolidation of Variable Interest Entities" ("FIN No. 46R"), which addresses how a business enterprise should evaluate whether it has a controlling financial interest in an entity through means other than voting rights and, accordingly, should consolidate the variable interest entity ("VIE"). FIN No. 46R replaces FIN No. 46 that was issued in January 2003. Merchants is required to apply FIN No. 46R to variable interests generally as of March 31, 2004 and to special-purpose entities as of December 31, 2003. The requirements of FIN 46R prohibit the consolidation of the Company's wholly owned subsidiary trust, formed to issue mandatorily redeemable preferred securities ("trust preferred securities"). As of December 31, 2004 this results in the recognition of junior subordinated debentures of $20.62 million and an investment in the subsidiary trust of $619 thousand in the Company's 2004 consolidated balance sheet.
In December 2004, the FASB issued revised statement No. 123 ("FAS 123R"), "Share-Based Payment", which requires companies to expense the estimated fair value of employee stock options and similar awards. The accounting provisions of FAS 123R will be effective for public companies beginning July 1, 2005. Merchants will adopt the provisions of FAS 123R using a modified prospective application. Under the modified prospective application, FAS 123R, which provides certain changes to the method for valuing stock-based compensation among other changes, will apply to new awards and to awards that are outstanding on the effective date and are subsequently modified or cancelled. Compensation expense for outstanding awards for which the requisite service has not been rendered as of the effective date will be recognized over the remaining service period using the compensation cost calculated for pro forma disclosure purposes under FAS 123. Merchants is in the process of determining how the new method of valuing stock-based compensation as prescribed in FAS 123R will be applied to valuing stock-based awards granted after the effective date and the impact the recognition of compensation expense related to such awards will have on its financial statements.
Intangible Assets
Premiums paid for the purchase of core deposits are recorded as other assets and amortized using straight-line and accelerated methods over 7 to 15 years. Management periodically reviews the value of the intangible asset by comparing purchased deposit levels to the current level of acquired deposits in the branches purchased. If any significant deposit runoff has occurred and is determined to be permanent in nature, the asset is written down accordingly. As of December 31, 2004, such intangible assets totaled approximately $909 thousand and are included in other assets on the consolidated balance sheets. Amortization of such intangible assets amounted to $327 thousand, $346 thousand, and $410 thousand in 2004, 2003, and 2002 respectively. Amortization for these intangibles for the five years subsequent to December 31, 2004 is: 2005--$327 thousand; 2006--$304 thousand; 2007--$185 thousand; 2008--$93 thousand; and zero thereafter.
Stock-Based Compensation
Merchants accounts for its stock-based compensation plans in accordance with the provisions of Accounting Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations. On January 1, 1996, Merchants adopted SFAS No. 123, "Accounting for Stock-Based Compensation," which permits entities to recognize as expense over the vesting period the fair value of all stock based awards measured on the date of the grant. Alternatively, SFAS No. 123 allows entities to continue to apply the provisions of APB Opinion No. 25 and provide pro forma net income and earnings per share disclosures for employee stock-based grants made in 1995 and future years as if the fair value based method defined in SFAS No. 123 had been applied. In December 2004, FASB issued FAS 123(R) which, unlike FAS 123, requires all companies to expense all stock options and awards effective beginning the first fiscal quarter after June 15, 2005. Until that time, Merchants has elected to continue to apply the provisions of APB Opinion No. 25 and provide the pro forma disclosure of SFAS No. 123.
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Merchants has granted stock options to certain key employees. The options granted vest after two years and are immediately exercisable upon vesting. Nonqualified stock options may be granted at any price determined by the Nominating and Governance Committee of Merchants' Board of Directors. All stock options have been granted at or above fair market value at the date of grant.
No options were granted during 2004, 2003 or 2002. The fair value of each option grant is estimated on the grant date using the Black-Scholes option-pricing model. The resulting pro-forma after tax compensation expense was zero for 2004, zero for 2003 and $6 thousand for 2002.
As permitted by SFAS No. 123, Merchants has elected to continue to apply APB Opinion No. 25 to account for its stock-based compensation plans for 2004. Had compensation cost for awards under Merchants' stock-based compensation plans been determined consistent with the method set forth under SFAS No. 123, the effect on Merchants' net income and earnings per share would have been as follows:
As
Pro
As
Pro
As
Pro
(In thousands except per share data)
Reported
Forma
Reported
Forma
Reported
Forma
Net Income
$11,933
$11,933
$11,592
$11,592
$12,617
$12,611
Basic Earnings per Share
$ 1.91
$ 1.91
$ 1.87
$ 1.87
$ 2.05
$ 2.05
Diluted Earnings per Share
$ 1.90
$ 1.90
$ 1.86
$ 1.86
$ 2.02
$ 2.02
Pro forma compensation expense for options granted is reflected over the vesting period; therefore, future pro forma compensation expense may be greater as additional options are granted.
The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option-pricing models require the input of highly subjective assumptions. Because Merchants' employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.
Employee Benefit Costs
Prior to 1995 Merchants maintained a non-contributory pension plan covering substantially all employees that met eligibility requirements. The plan was curtailed in 1995. The cost of this plan, based on actuarial computations of current and future benefits, is charged to current operating expenses.
Earnings Per Share
Basic earnings per share are calculated by dividing net income available to common shareholders by the weighted average number of common shares outstanding during the period. Diluted earnings per share are computed in a manner similar to that of basic earnings per share except that the weighted average number of common shares outstanding is increased to include the number of additional common shares that would have been outstanding if all potentially dilutive common shares (such as stock options and unvested restricted stock awards) were issued during the period, computed using the treasury stock method.
Derivative Financial Instruments and Hedging Activities
Derivative instruments utilized by Merchants have included interest rate floor and swap agreements. Merchants is an end-user of derivative instruments and does not conduct trading activities for derivatives.
Merchants follows the provisions of SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the balance sheet and measure those instruments at fair value. Changes in the fair value of the derivative financial instruments are reported in either net income or as a component of other comprehensive income, depending on the use of the derivative and whether or not it qualifies for hedge accounting. As of December 31, 2004, there were no derivatives being used by Merchants.
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SECURITIES HELD TO MATURITY:
Actual maturities will differ from contractual maturities because borrowers may have rights to call or prepay obligations. Maturities of mortgage-backed securities and collateralized mortgage obligations are based on final contractual maturities.
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Proceeds from sales of available for sale debt securities were $66.11 million during 2004 and $100.4 million during 2003. Gross gains of $1.00 million, $1.53 million and $610 thousand; and gross losses of $952 thousand, $114 thousand and zero, were realized from sales of securities in 2004, 2003, and 2002 respectively.
At December 31, 2004, securities with a book value of $10.7 million were pledged to secure public deposits, 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 December 31, 2004, were as follows:
There were no securities held to maturity with unrealized losses as of December 31, 2004.
U.S. Treasury and Agency Securities:
Unrealized losses on investments in U.S. Treasury and Agency securities were caused by interest rate fluctuations.
Mortgage-backed Securities:
The unrealized losses on investments in mortgage-backed securities were caused by interest rate fluctuations. The cash flows of these securities are guaranteed by the Federal Home Loan Mortgage Corporation ("FHLMC") or Federal National Mortgage Association ("FNMA"). There are two securities that have been in an unrealized loss position for 12 months or more. The percentage loss on these two securities ranges from .04% to 1.3%, which Merchants considers minor.
Commercial Mortgage Backed Securities (CMBS):
The unrealized losses in CMBS were caused by interest rate fluctuations. These bonds are backed by a variety of types of commercial real estate. Merchants looks at the overall structure of these bonds for, among other things, low historical default rates, low loan-to-value rates, prepayment penalties and lock-outs, and good geographic and property type diversity as part of its pre-purchase evaluation. There are five securities that have been in an unrealized loss position for 12 months or more, the percentage loss on these bonds range from .56% to 2.89%, which Merchants considers minor.
Collateralized Mortgage Obligations (CMOs):
The unrealized losses on investments in collateralized mortgage obligations were caused by interest rate fluctuations. The cash flows of twenty-two out of the thirty-four CMOs with unrealized losses totaling $425 thousand at December 31, 2004, were guaranteed by FHLMC or FNMA. The remaining twelve securities with a $468 thousand balance of unrealized losses in this asset class represent a 1.34% loss on the total book balance of $35.0 million. There are three securities that have been in an unrealized loss position for 12 months or more, all three of these bonds are guaranteed by FHLMC or FNMA. The individual losses on those bonds range from .68% to 2.3%, which Merchants considers minor.
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Total impaired loans were $3.8 million and $2.7 million at December 31, 2004 and 2003, respectively. The Allowance associated with such loans was approximately $72 thousand and $22 thousand, respectively. Interest payments on impaired loans are generally recorded as principal reductions if the remaining loan balance is not expected to be paid in full. If full collection of the remaining loan balance is expected, interest income is recognized on a cash basis. Merchants recorded interest income on impaired loans of approximately $50 thousand, $90 thousand and $80 thousand during 2004, 2003 and 2002, respectively. The average balance of impaired loans was $2.8 million in 2004, $3.9 million in 2003 and $3.7 million in 2002.
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Depreciation and amortization expense related to premises and equipment amounted to $2.2 million, $1.8 million, and $1.9 million in 2004, 2003 and 2002, respectively.
Merchants leases certain properties for branch operations. Rent expense on these properties totaled $572 thousand, $537 thousand and $397 thousand for the years ended December 31, 2004, 2003 and 2002, respectively. Minimum lease payments for these properties subsequent to December 31, 2004, are as follows: 2005--$520 thousand; 2006--$488 thousand; 2007--$455 thousand; 2008--$375 thousand; 2009--$265 thousand and $1.3 million thereafter.
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Maturities of short-term borrowings are less than two months with interest rates at December 31, 2004, ranging from 2.15% to 2.38%.
As of December 31, 2004, Merchants could borrow up to approximately $43 million in overnight funds. $28 million of this $43 million are unsecured borrowing lines established with correspondent banks, the balance of $15 million is in the form of an overnight line of credit with the FHLB. Merchants has established both overnight and longer term lines of credit with the FHLB. The borrowings are secured by mortgage loans and FHLB stock held by Merchants. The total amount of assets pledged to the FHLB for both short and long-term borrowing arrangements totaled $214.95 and $214.29 million at December 31, 2004 and 2003 respectively.
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The 8.75% Mortgage Note relates to an investment in an affordable housing project made through a consolidated limited partnership. The monthly installments are subsidized by the U.S. Department of Agriculture, which pays amounts annually so as to reduce the monthly principal and interest payments to an amount equivalent to a loan at a rate of 1%.
The Directors Floating Growth (Savings) program relates to a deferred compensation plan for directors. Until July 1, 1997, Directors of Merchants were entitled to defer a portion of their director's fees into this deferred plan. No additional compensation may be deferred into the Floating Growth (savings) program. Benefits accrue based on a monthly allowance for interest at a rate that is fixed from time-to-time at the discretion of Merchants' Board of Directors. The benefits under the Floating Growth (savings) program are generally payable annually starting in January of the year following a participant's 65th birthday or earlier death, and will be distributed to the participant (or upon the participant's death, to the participant's designated beneficiary) in accordance with the terms of the Floating Growth (savings) plan.
Maturities of long term debt subsequent to December 31, 2004, are as follows: 2005--$29.24 million; 2006--$16.54 million; 2007--$1.55 million; 2008--$332 thousand; 2009--$190 thousand and $1.91 million thereafter.
As of December 31, 2004, Merchants had an estimated additional borrowing capacity with the Federal Home Loan Bank of $50 million; and the ability to borrow through the use of repurchase agreements, collateralized by Merchants' investments, with certain approved counterparties.
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Low-income housing tax credits are eligible for a 20 year carryforward.
In addition to the deferred tax assets and liabilities described above, Merchants had a deferred tax liability related to the net unrealized gain on securities available for sale of $54 thousand and $690 thousand at December 31, 2004 and 2003, respectively. Merchants also had a deferred tax asset of $1.30 million and $1.36 million at December 31, 2004 and 2003, respectively, related to the recognition of a minimum pension liability as of December 31, 2004.
In assessing the realizability of Merchants' total deferred tax assets, management considers whether it is more likely than not that some portion or all of those assets will not be realized. Based upon management's consideration of historical and anticipated future pre-tax income, as well as the reversal period for the items giving rise to the deferred tax assets and liabilities, a valuation allowance for deferred tax assets was not considered necessary at December 31, 2004 and 2003. Merchants had a tax refund receivable at December 31, 2004 totaling approximately $1.75 million.
The following is a reconciliation of the federal income tax provision, calculated at the statutory rate of 35%, to the recorded provision for income taxes:
The State of Vermont assesses a franchise tax for banks in lieu of income tax. The franchise tax is assessed based on deposits and amounted to approximately $870 thousand, $787 thousand and $817 thousand in 2004, 2003 and 2002, respectively.
(10) EMPLOYEE BENEFIT PLANS
Pension Plan
Prior to January 1995 Merchants maintained a noncontributory defined benefit plan covering all eligible employees. The plan was a final average pay plan with benefits based on the average salary rates over the five consecutive plan years out of the last ten consecutive plan years that produce the highest average. It was Merchants policy to fund the cost of benefits expected to accrue during the year plus amortization of any unfunded accrued liability that had accumulated prior to the valuation date based on IRS regulations for funding. During 1995 the plan was curtailed. Accordingly, all accrued benefits were fully vested and no additional years of service or age will be accrued.
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The following table sets forth the target asset allocation, and the asset allocation percentages as of December 31, 2004 and 2003, for Merchants' Pension Plan:
Target
Allocation
Allocation
Percentage
12/31/2004
Allocation
Percentage
12/31/2003
Equity Securities
60--70%
67%
64%
Debt Securities
30--40%
30%
31%
Other/Cash
--
3%
5%
Total
100%
100%
Merchants' Pension Plan Investment Policy Statement sets forth the investment objectives and constraints of Merchants' pension plan (the "Plan"). The purpose of the policy is to assist the Retirement Plan Committee of Merchants in effectively supervising, monitoring and evaluating the investments of the Plan.
The investment objectives are to provide both income and capital appreciation and to assist with current and future spending needs of the Plan while at the same time minimizing the risks of investing. The investment target of the Plan is to achieve a total annual rate of return in excess of the change in the Consumer Price Index for the aggregate investments of the Plan evaluated over a period of five years. A certain amount of risk must be assumed to achieve the Plan's investment target rate of return. The Plan diversifies its assets to help to minimize the risks of investing. The Plan also uses a long time horizon to evaluate its returns. The Plan's asset allocation is based on this long-term perspective.
Specific guidelines regarding allocation of assets are as follows: equities shall be managed to a target of 65% of total investments and fixed income securities will be managed to a target of 35% of total investments, with a 5% tolerance either below or above, as measured on a quarterly basis. If the exposure for equities is less than 60% or greater than 70%, or the exposure for fixed income is less than 30% or greater than 40% at the end of any quarter, the assets will be rebalanced in order to restore the equity exposure.
Merchants' expected minimum required contribution to the Plan is expected to be in the range of zero to $800 thousand for 2005.
The following table summarizes the estimated future benefit payments expected to be paid under the Plan:
The estimated future benefit payments expected to be paid under the Plan are based on the same assumptions used to measure Merchants' benefit obligation at December 31, 2004. No future service estimates were included due to the frozen status of the Plan.
401(k) Employee Stock Ownership Plan
Under the terms of Merchants' 401(k) Employee Stock Ownership Plan ("401(k)") eligible employees are entitled to contribute up to 75% of their compensation to the 401(k), and Merchants contributes a percentage of the amounts contributed by the employees as authorized by Merchants' Board of Directors. Merchants contributed approximately 110%, 111%, and 120% of the amounts contributed by the employees (200% of up to 4.5% of individual employee compensation) in 2004, 2003 and 2002, respectively.
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As of December 31, 2004, there were options outstanding within the following ranges: 215 thousand at prices within the range of $15.50 to $20.00, and 65 thousand at prices within the range of $20.01 to $23.00. The weighted average remaining contractual life of the outstanding options was three years as of December 31, 2004.
Deferred Compensation Plans
In December 1995 Merchants established several plans (the "Plans") and established certain trusts (the "Trusts") with Merchants Trust Company, to which it contributed an amount sufficient to cover Merchants' obligations to directors. The Plans used those payments, in part, to purchase newly issued common stock of Merchants at its then market price. The purchases have been accounted for as treasury stock transactions in Merchants' consolidated financial statements. The portions of the payments made to the Plans that were not invested in the common stock of Merchants were included as investments in the consolidated financial statements and were classified as trading. To the extent the obligations of Merchants under the Plans are based on investments by the Plans in other than shares of Merchants, the investments were revalued at each reporting date with a corresponding adjustment to compensation expense in the consolidated statement of operations. The portion of the Plan that was not held in shares of Merchants was paid out in December of 2004.
Restricted Stock Plans
Merchants has compensation plans for non-employee directors. Under the terms of these plans participating directors may elect to have all, or a specified percentage of their director's fees for a given year, paid in the form of cash or deferred in the form of restricted shares of Merchants' common stock. Directors who elect to have their compensation deferred are credited with a number of shares of Merchants common stock equal in value to the amount of fees deferred plus a risk premium of not more than 25% of the amount deferred. The participating director may not generally sell, transfer or otherwise dispose of these shares prior to the fifth anniversary of the date of the grant of such shares. With respect to shares of common stock issued or otherwise transferred to a participating director, the participating director will have the right to vote the shares and receive dividends or other distributions thereon. If a participating director resigns under certain circumstances, the director forfeits all of his or her restricted shares which are risk premium
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(15) 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. Merchants uses the same credit policies in making commitments as it does for on-balance sheet instruments. The contractual amounts of these financial instruments at December 31, 2004 and 2003 are as follows:
(In thousands)
Contractual Amount
Financial Instruments Whose Contract Amounts
Represent Credit Risk:
Commitments to Originate Loans
$ 28,155
Unused Lines of Credit
103,273
Standby Letters of Credit
8,746
Equity Commitments to Affordable Housing
Limited Partnerships
4,851
(In thousands)
Contractual Amount
Financial Instruments Whose Contract Amounts
Represent Credit Risk:
Commitments to Originate Loans
$ 19,360
Unused Lines of Credit
103,941
Standby Letters of Credit
6,984
Loans Sold with Recourse
Equity Commitments to Affordable Housing
Limited Partnerships
8,396
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 commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent a future cash requirement. Merchants evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained by Merchants upon extension of credit is based on management's credit evaluation of the counterparty, and an appropriate amount of real and/or personal property is obtained as collateral.
FASB Interpretation No. 45 ("FIN No. 45"), "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others; an Interpretation of FASB Statements No. 5, 57, and 107 and rescission of FASB Interpretation No. 34", requires certain disclosures and liability-recognition for the fair value at issuance of guarantees that fall within its scope. Under FIN No. 45, Merchants does not issue any guarantees that would require liability-recognition or disclosure, other than its standby letters of credit. Merchants has issued conditional commitments in the form of standby letters of credit to guarantee payment on behalf of a customer and guarantee the performance of a customer to a third party. Standby letters of credit generally arise in connection with lending relationships. The credit risk involved in issuing these instruments is essentially the same as that involved in extending loans to customers. Contingent obligations under standby letters of credit totaled approximately $8.7 million and $7.0 million at December 31, 2004 and 2003, respectively, and represent the maximum potential future payments Merchants could be required to make. Typically, these instruments have terms of 12 months or less and expire unused; therefore, the total amounts do not necessarily represent future cash requirements. Each customer is evaluated individually for
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creditworthiness under the same underwriting standards used for commitments to extend credit and on-balance sheet instruments. Merchants' policies governing loan collateral apply to standby letters of credit at the time of credit extension. Loan-to-value ratios are generally consistent with loan-to-value requirements for other commercial loans secured by similar types of collateral. The fair value of Merchants' standby letters of credit at December 31, 2004 and 2003 was insignificant.
Merchants may enter into commitments to sell loans, which involve market and interest rate risk. There were no such commitments at December 31, 2004 or 2003.
Interest Rate Cap and Floor Contracts
Interest rate caps allow the purchaser to "cap" the contractual rate associated with a liability; alternatively interest rate floors allow the purchaser to protect the rate of return on an asset. Merchants may use floor contracts to mitigate the effects on net interest income in the event interest rates on floating rate loans decline and may use cap contracts to mitigate the effects on net interest income should interest rates on floating rate deposits increase. As of December 31, 2004, there were no interest rate cap or floor contracts outstanding.
Interest Rate Swaps
An interest rate swap is an agreement whereby two parties agree to exchange periodic interest payments, most commonly one party agrees to pay the other party interest payments of a fixed rate; and the other party agrees to make interest payments at a rate that floats with a specified index. There is no exchange of the underlying principal amounts. Merchants uses swap agreements to mitigate the effect on net interest income should floating rates on loans decrease. Merchants is exposed to risk should the counterparty default in its responsibility to pay interest under the terms of the swap agreement, but minimizes this risk by performing normal credit reviews on the counterparties, limiting its exposure to any one counterparty, and by utilizing well known national investment firms as counterparties. Notional principal amounts are a measure of the volume of agreements transacted, but the level of credit risk is significantly less. Merchants entered into a $25 million, three year, interest rate swap early in the second quarter of 2002. Merchants received a fixed interest rate and paid prime under the agreement. Merchants terminated the swap and realized a $1.3 million gain during October, 2002. The gain is being accreted into income monthly through April 2005, using the effective yield method. There were no interest rate swap contracts outstanding as of December 31, 2004 or 2003.
Balances at the Federal Reserve Bank
At December 31, 2004 and 2003, amounts at the Federal Reserve Bank included $7.8 million and $3.2 million, respectively, held to satisfy certain reserve requirements of the Federal Reserve Bank.
Legal Proceedings
Merchants and certain of its subsidiaries have been named as defendants in various legal proceedings arising from their normal business activities. Although the amount of any ultimate liability with respect to such proceedings cannot be determined, in the opinion of management, based upon the opinion of counsel on the outcome of such proceedings, any such liability will not have a material effect on the consolidated financial position of Merchants and its subsidiaries.
(16) FAIR VALUE OF FINANCIAL INSTRUMENTS
Investments
The carrying amounts reported in the consolidated balance sheets for cash and cash equivalents and the Federal Home Loan Bank stock approximate fair values. Fair value for investment securities is determined from quoted market prices, when available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments.
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Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholders
of Merchants Bancshares, Inc.:
We have audited the accompanying consolidated balance sheets of Merchants Bancshares, Inc. and subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of operations, changes in shareholders' equity, comprehensive income, and cash flows for each of the years in the three year period ended December 31, 2004. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Merchants Bancshares, Inc. and subsidiaries as of December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company's internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 28, 2005, expressed an unqualified opinion on management's assessment of, and the effective operation of, internal control over financial reporting.
/s/ KPMG LLP
Albany, New York
February 28, 2005
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Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholders
of Merchants Bancshares, Inc.:
We have audited management's assessment, included in the accompanying Management's Report on Internal Control Over Financial Reporting, that Merchants Bancshares, Inc. (the "Company") maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the Company's internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management's assessment that Merchants Bancshares, Inc. maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on criteria established in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Merchants Bancshares, Inc. and subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of operations, changes in shareholders' equity, comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2004, and our report dated February 28, 2005 expressed an unqualified opinion on those consolidated financial statements.
/s/ KPMG LLP
Albany, New York
February 28, 2005
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ITEM 9
ITEM 9 - -CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURES
None.
ITEM 9A
ITEM 9A - -CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
The principal executive officer and principal financial officer of Merchants have evaluated the disclosure controls and procedures as of December 31, 2004. Based on this evaluation, the principal executive officer and principal financial officer have concluded that the disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) effectively ensure that information required to be disclosed in Merchants' filings and submissions with the Securities and Exchange Commission under the Exchange Act, is recorded, processed, summarized and reported within the time periods specified by the Securities and Exchange Commission. In addition, Merchants has reviewed its internal controls and there have been no significant changes in its internal controls or in other factors during Merchants' most recent fiscal quarter that have materially affected internal control over financial reporting.
Management's Report on Internal Control Over Financial Reporting--
Management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rule 13a-15(f). Merchants internal control system was designed to provide reasonable assurances to Merchants management and board of directors regarding the preparation and fair presentation of published financial statements. Under the supervision and with the participation of Merchants' management, including its principal executive officer and principal financial officer, an evaluation was conducted of the effectiveness of internal controls over financial reporting based on the framework in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on the evaluation under the framework in Internal Control--Integrated Framework, management concluded that the internal controls over financial reporting were effective as of December 31, 2004. Management's assessment of the effectiveness of internal control over financial reporting as of December 31, 2004 has been audited by KPMG LLP, an independent registered public accounting firm, as stated in their report which is included herein.
PART III
ITEM 10
ITEM 10 - -DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
ITEM 11
ITEM 11 - -EXECUTIVE COMPENSATION
ITEM 12
ITEM 12 - -SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
AND RELATED STOCKHOLDER MATTERS
ITEM 13
ITEM 13 - -CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
ITEM 14
ITEM 14 - -PRINCIPAL ACCOUNTANT FEES AND SERVICES
Reference is hereby made to pages 3-5, page 12, pages 10-11, pages 17-18, pages 14-15 and page 19 of Merchants' Proxy Statement to Shareholders dated March 18, 2005, wherein pursuant to Regulation 14A information concerning the above subjects (Items 10 through 14) is incorporated by reference.
Pursuant to Rule 12b-23, definitive copies of the Proxy Statement will be filed within 120 days subsequent to the end of Merchants fiscal year covered by Form 10-K.
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