Merchants Bancshares 10-Q 2013 Q1 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended March 31, 2013

or

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

For the transition period from	to
Commission File Number: 0-11595
Merchants Bancshares, Inc.
(Exact name of registrant as specified in its charter)
Delaware	03-0287342
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
275 Kennedy Drive, South Burlington, VT	05403
(Address of principal executive offices)	(Zip Code)
802-658-3400
(Registrant’s telephone number, including area code)
Not Applicable
(Former name, former address and former fiscal year, if changed since last report)

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

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

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

Large Accelerated Filer [   ]Accelerated Filer [ X ]Nonaccelerated Filer [   ]  Smaller Reporting Company [  ]

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

[  ] Yes  [ X ] No

As of April  25, 2013, there were 6,291,905 shares of the registrant’s common stock, par value $0.01 per share, outstanding.

MERCHANTS BANCSHARES, INC. AND SUBSIDIARIES

FORM 10-K

TABLE OF CONTENTS

PART I – FINANCIAL INFORMATION		Page Reference
Item 1	Financial Statements
	Consolidated Balance Sheets (Unaudited)
	As of March 31, 2013 and December 31, 2012	3
	Consolidated Statements of Income (Unaudited)
	Three months ended March 31, 2013 and 2012	4
	Consolidated Statements of Comprehensive Income (Unaudited)
	Three months ended March 31, 2013 and 2012	5
	Consolidated Statements of Cash Flows (Unaudited)
	Three months ended March 31, 2013 and 2012	6
	Notes to Interim Unaudited Consolidated Financial Statements	7
Item 2	Management's Discussion and Analysis of Financial Condition and Results of Operations	27
Item 3	Quantitative and Qualitative Disclosures about Market Risk	38
Item 4	Controls and Procedures	40
PART II - OTHER INFORMATION
Item 1	Legal Proceedings	41
Item 1A	Risk Factors	41
Item 2	Unregistered Sales of Equity Securities and Use of Proceeds	41
Item 3	Defaults Upon Senior Securities	41
Item 4	Mine Safety Disclosure	41
Item 5	Other Information	41
Item 6	Exhibits	41
	Signatures	42

2

ITEM 1 – FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Merchants Bancshares, Inc.

Consolidated Balance Sheets

(Unaudited)

	March 31,		December 31,
(In thousands except share and per share data)	2013		2012
ASSETS
Cash and due from banks	$	25,537	$	34,547
Interest earning deposits with banks and other short-term investments		17,486		42,681
Total cash and cash equivalents		43,023		77,228
Investments:
Securities available for sale, at fair value		507,994		508,681
Securities held to maturity (fair value of $403 and $454)		366		407
Total investments		508,360		509,088
Loans		1,101,713		1,082,923
Less: Allowance for loan losses		11,796		11,562
Net loans		1,089,917		1,071,361
Federal Home Loan Bank stock		7,496		8,145
Bank premises and equipment, net		16,404		16,077
Investment in real estate limited partnerships		5,211		5,423
Other assets		22,185		21,228
Total assets	$	1,692,596	$	1,708,550
LIABILITIES
Deposits:
Demand (noninterest bearing)	$	225,884	$	240,491
Savings, interest bearing checking and money market accounts		708,797		700,191
Time deposits $100 thousand and greater		130,322		123,371
Other time deposits		204,774		207,027
Total deposits		1,269,777		1,271,080
Short-term borrowings		30,900		0
Securities sold under agreements to repurchase		243,204		287,520
Other long-term debt		2,463		2,483
Junior subordinated debentures issued to unconsolidated subsidiary trust		20,619		20,619
Other liabilities		6,479		8,627
Total liabilities		1,573,442		1,590,329
Commitments and contingencies (Note 8)
SHAREHOLDERS' EQUITY
Preferred stock
Class A non-voting shares authorized - 200,000, none outstanding		0		0
Class B voting shares authorized - 1,500,000, none outstanding		0		0
Common stock, $.01 par value		67		67
Authorized 10,000,000 shares; Issued 6,651,760 at March 31, 2013 and December 31, 2012
Outstanding: 6,289,748 at March 31, 2013 and 6,282,385 at December 31, 2012
Capital in excess of par value		36,788		36,742
Retained earnings		89,430		87,580
Treasury stock, at cost: 362,012 shares at March 31, 2013 and 369,375 shares at December 31, 2012		(14,291)		(14,786)
Deferred compensation arrangements: 305,231 shares at March 31, 2013 and 324,515 shares at December 31, 2012		6,122		6,403
Accumulated other comprehensive income		1,038		2,215
Total shareholders' equity		119,154		118,221
Total liabilities and shareholders' equity	$	1,692,596	$	1,708,550
See accompanying notes to unaudited consolidated financial statements

3

Merchants Bancshares, Inc.

Consolidated Statements of Income

(Unaudited)

	Three Months Ended
	March 31,
(In thousands except per share data)	2013		2012
INTEREST AND DIVIDEND INCOME
Interest and fees on loans	$	10,784	$	11,329
Investment income:
Interest and dividends on investment securities		2,785		3,080
Interest on interest earning deposits with banks and other short-term investments		12		10
Total interest and dividend income		13,581		14,419
INTEREST EXPENSE
Savings, interest bearing checking and money market accounts		167		226
Time deposits $100 thousand and greater		235		280
Other time deposits		344		454
Securities sold under agreement to repurchase and other short-term debt		357		576
Long-term debt		196		447
Total interest expense		1,299		1,983
Net interest income		12,282		12,436
Provision for credit losses		250		250
Net interest income after provision for credit losses		12,032		12,186
NONINTEREST INCOME
Net gains on investment securities		0		76
Trust division income		758		657
Service charges on deposits		987		977
Equity in losses of real estate limited partnerships		(270)		(410)
Other		1,003		1,061
Total noninterest income		2,478		2,361
NONINTEREST EXPENSE
Compensation and benefits		4,795		5,188
Occupancy expense		1,064		974
Equipment expense		946		904
Legal and professional fees		687		611
Marketing		280		411
State franchise  taxes		357		328
FDIC insurance		220		215
Other Real Estate Owned ("OREO") expenses		13		33
Other		1,522		1,439
Total noninterest expense		9,884		10,103
Income before provision for income taxes		4,626		4,444
Provision for income taxes		1,017		831
NET INCOME	$	3,609	$	3,613
Basic earnings per common share	$	0.57	$	0.58
Diluted earnings per common share	$	0.57	$	0.58
See accompanying notes to consolidated financial statements

4

Merchants Bancshares, Inc.

Consolidated Statements of Comprehensive Income

(Unaudited)

	Three Months Ended
	March 31,
(In thousands)	2013		2012
Net income	$	3,609	$	3,613
Other comprehensive (loss) income,  net of tax:
Change in net unrealized gain (loss) on securities available for sale, net of taxes of $(692) and $206		(1,285)		383
Reclassification adjustments for net securities losses (gains) included in net income, net of taxes of $0 and $(26)		0		(50)
Change in net unrealized loss on interest rate swaps, net of taxes of $26 and $43		48		80
Pension liability adjustment, net of taxes of $32 and $22		60		41
Other comprehensive (loss) income		(1,177)		454
Comprehensive income	$	2,432	$	4,067
See accompanying notes to consolidated financial statements

5

Merchants Bancshares, Inc.

Consolidated Statements of Cash Flows

(Unaudited)

	Three months ended March 31,
(In thousands)	2013		2012
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	3,609	$	3,613
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses		250		250
Depreciation and amortization		512		498
Amortization of investment security premiums and accretion of discounts, net		402		686
Stock option expense		46		46
Net gains on sales of investment securities		0		(76)
Equity in losses of real estate limited partnerships, net		270		410
Changes in assets and liabilities:
Net change in interest receivable		(912)		(410)
Net change in other assets		707		(1,251)
Net change in interest payable		(3)		13
Net change in other liabilities		(2,111)		(10,670)
Net cash provided by (used in) operating activities		2,770		(6,891)
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from sales of investment securities available for sale		0		14,630
Proceeds from maturities of investment securities available for sale		39,112		51,706
Proceeds from maturities of investment securities held to maturity		41		42
Proceeds from redemption of Federal Home Loan Bank stock		649		486
Purchases of investment securities available for sale		(40,804)		(62,336)
Loan originations in excess of principal payments		(18,764)		(13,353)
Proceeds from sale of premises and equipment		1		0
Proceeds from sales of other real estate owned		0		8
Real estate limited partnership investments		(46)		(1,185)
Purchases of bank premises and equipment		(879)		(476)
Net cash used in investing activities		(20,690)		(10,478)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net (decrease) increase in deposits		(1,303)		22,781
Net increase in short-term borrowings		30,900		36,600
Net increase in securities sold under agreement to repurchase, short-term		(44,316)		(34,118)
Principal payments on long-term debt		(20)		(20)
Cash dividends paid		(1,606)		(1,574)
Sale of treasury stock		7		3
Increase in deferred compensation arrangements		53		49
Net cash (used in) provided by financing activities		(16,285)		23,721
(Decrease) increase in cash and cash equivalents		(34,205)		6,352
Cash and cash equivalents beginning of period		77,228		37,812
Cash and cash equivalents end of period	$	43,023	$	44,164
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Total interest payments	$	1,302	$	1,998
Total income tax payments		0		2,500
SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES
Distribution of stock under deferred compensation arrangements	$	446	$	432
Distribution of treasury stock in lieu of cash dividend		154		171
Decrease in payable for investments purchased		0		(9,461)
See accompanying notes to consolidated financial statements

6

Notes To Interim Unaudited Consolidated Financial Statements

For additional information, see the Merchants Bancshares, Inc. (“Merchants,” “we,” “us,” “our”) Annual Report on Form 10-K for the fiscal year ended December 31, 2012, filed with the Securities and Exchange Commission (the “SEC”) on March 6, 2013.

NOTE 1: FINANCIAL STATEMENT PRESENTATION

Principles of Consolidation

The accompanying unaudited interim consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and the instructions to the Quarterly Report on Form 10-Q and Rule 10-01 of Regulation S-X promulgated under the Securities Exchange Act of 1934, as amended. Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States of America for complete financial statements. All adjustments necessary for a fair presentation of our interim consolidated financial statements as of March 31, 2013 and December 31, 2012 and for the three months ended March 31, 2013 and 2012 have been included. The information was prepared from our unaudited financial statements and the unaudited financial statements of our subsidiaries, Merchants Bank and MBVT Statutory Trust I.  Amounts reported for prior periods are reclassified, where necessary, to be consistent with the current period presentation.

Management’s Use of Estimates in Preparation of Financial Statements

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of income and expenses during the reporting periods. The most significant estimates include those used in determining the allowance for loan losses, income taxes, interest income recognition on loans and investments and analysis of other-than-temporary impairment of investment securities. Operating results in the future may vary from the amounts derived from our estimates and assumptions.

NOTE 2: RECENT ACCOUNTING PRONOUNCEMENTS 

In February 2013, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2013-02, “Comprehensive Income (Topic 220) – Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income.” The objective of this update is to improve the reporting of reclassifications out of accumulated other comprehensive income. The amendments do not change the current requirements for reporting net income or other comprehensive income in financial statements. However, the amendments require an entity to provide information about the amounts reclassified out of accumulated other comprehensive income by component. In addition, an entity is required to present, either on the face of the statement where net income is presented or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income but only if the amount reclassified is required under U.S. GAAP to be reclassified to net income in its entirety in the same reporting period. For other amounts that are not required under U.S. GAAP to be reclassified in their entirety to net income, an entity is required to cross-reference to other disclosures required under U.S. GAAP that provide additional detail about those amounts. The amendments in this update apply to all entities that issue financial statements that are presented in conformity with U.S. GAAP and that report items of other comprehensive income. Public companies are required to comply with these amendments for all reporting periods presented, including interim periods. For public entities, the amendments are effective prospectively for reporting periods beginning after December 15, 2012.  Adoption of this update did not have a material impact on our financial condition or results of operations.

In January 2013, the FASB issued ASU 2013-01, “Balance Sheet (Topic 210) – Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities.” The main objective in developing this update is to address implementation issues about the scope of ASU 2011-11, “Balance Sheet (Topic 210) – Disclosures about Offsetting Assets and Liabilities.” The amendments clarify that the scope of ASU 2011-11 applies only to derivatives, repurchase agreements and reverse repurchase agreements, and securities borrowing and securities lending transactions that are either offset in accordance with specific criteria contained in the ASC or otherwise subject to a master netting arrangement or similar agreement.  ASU 2011-11 requires an entity to disclose information about offsetting and related arrangements to enable users of its financial statements to understand the effect of those arrangements on its financial statements. This includes the effect or potential effect of rights of offset associated with an entity’s recognized assets and liabilities that are subject to the ASU. Consistent with ASU 2011-11, an entity is required to apply the amendments for fiscal years beginning on or after January 1, 2013, and interim periods within those annual periods. An entity should provide the required disclosures retrospectively for all comparative periods presented. The effective date is the same as the effective date of ASU 2011-11. Adoption of the update did not have a material impact on our financial condition or results of operations.

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NOTE 3: INVESTMENT SECURITIES

Investments in securities are classified as available for sale or held to maturity as of March 31, 2013 and December 31, 2012. The amortized cost and fair values of the securities classified as available for sale and held to maturity as of March 31, 2013 are as follows:

			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
(In thousands)	Cost		Gains		Losses		Value
Available for Sale:
U.S. Treasury Obligations	$	100	$	0	$	0	$	100
U.S. Agency Obligations		25,959		25		173		25,811
U.S. Government Sponsored Enterprises ("U.S. GSEs")		46,144		609		164		46,589
Federal Home Loan Bank ("FHLB") Obligations		22,528		19		106		22,441
Residential Real Estate Mortgage-backed Securities ("Agency MBSs")		130,551		5,313		11		135,853
Agency Commercial Mortgage Backed Securities ("Agency CMBSs")		18,764		13		87		18,690
Agency Collateralized Mortgage Obligations ("Agency CMOs")		225,112		2,498		640		226,970
Non-agency Collateralized Mortgage Obligations ("Non-agency CMOs")		4,346		29		0		4,375
Collateralized Loan Obligations ("CLOs")		26,799		0		49		26,750
Asset Backed Securities ("ABSs")		357		58		0		415
Total Available for Sale	$	500,660	$	8,564	$	1,230	$	507,994
Held to Maturity:
Agency MBSs	$	366	$	37	$	0	$	403
Total Held to Maturity	$	366	$	37	$	0	$	403

The amortized cost and fair values of the securities classified as available for sale and held to maturity as of December 31, 2012 are as follows:

			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
(In thousands)	Cost		Gains		Losses		Value
Available for Sale:
U.S. Treasury Obligations	$	100	$	0	$	0	$	100
U.S. Agency Obligations		10,956		0		59		10,897
U.S. GSEs		58,731		723		88		59,366
FHLB Obligations		24,546		39		0		24,585
Agency MBSs		142,441		6,326		0		148,767
Agency CMBSs		5,087		0		58		5,029
Agency CMOs		227,815		2,922		338		230,399
Non-agency CMOs		4,589		6		2		4,593
CLOs		24,748		0		221		24,527
ABSs		357		61		0		418
Total Available for Sale	$	499,370	$	10,077	$	766	$	508,681
Held to Maturity:
Agency MBSs	$	407	$	47	$	0	$	454
Total Held to Maturity	$	407	$	47	$	0	$	454

8

The contractual final maturity distribution of the debt securities classified as available for sale and held to maturity as of March 31, 2013, are as follows:

			After One		After Five
	Within		But Within		But Within		After Ten
(In thousands)	One Year		Five Years		Ten Years		Years		Total
Available for Sale (at fair value):
U.S. Treasury Obligations	$	0	$	100	$	0	$	0	$	100
U.S. Agency Obligations		0		0		0		25,811		25,811
U.S. GSEs		0		2,512		44,077		0		46,589
FHLB Obligations		0		0		22,441		0		22,441
Agency MBSs		151		4,614		19,321		111,767		135,853
Agency CMBSs		0		0		13,829		4,861		18,690
Agency CMOs		0		0		3,877		223,093		226,970
Non-agency CMOs		0		0		0		4,375		4,375
CLOs		0		0		26,750		0		26,750
ABSs		0		0		0		415		415
Total Available for Sale	$	151	$	7,226	$	130,295	$	370,322	$	507,994
Held to Maturity (at amortized cost):
Agency MBSs	$	6	$	63	$	0	$	297	$	366
Total Held to Maturity	$	6	$	63	$	0	$	297	$	366

The contractual final maturity distribution of the debt securities classified as available for sale and held to maturity as of December 31, 2012, are as follows:

			After One		After Five
	Within		But Within		But Within		After Ten
(In thousands)	One Year		Five Years		Ten Years		Years		Total
Available for Sale (at fair value):
U.S. Treasury Obligations	$	0	$	100	$	0	$	0	$	100
U.S. Agency Obligations		0		0		0		10,897		10,897
U.S. GSEs		0		10,025		49,341		0		59,366
FHLB Obligations		0		0		24,585		0		24,585
Agency MBSs		316		3,387		22,854		122,210		148,767
Agency CMBSs		0		0		5,029		0		5,029
Agency CMOs		0		0		4,139		226,260		230,399
Non-agency CMOs		0		0		0		4,593		4,593
CLOs		0		0		24,527		0		24,527
ABSs		0		0		0		418		418
Total Available for Sale	$	316	$	13,512	$	130,475	$	364,378	$	508,681
Held to Maturity (at amortized cost):
Agency MBSs	$	11	$	73	$	0	$	323	$	407
Total Held to Maturity	$	11	$	73	$	0	$	323	$	407

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

9

The following table presents the proceeds, gross gains and gross losses on available for sale securities for the three months ended March 31, 2013 and 2012.

(In thousands)	2013		2012
Proceeds	$	0	$	14,630
Gross gains		0		122
Gross losses		0		(46)
Net gains	$	0	$	76

We did not sell any securities during the three months ended March 31, 2013.

Securities with a carrying amount of $295.44 million and $349.52 million at March 31, 2013 and December 31, 2012, respectively, were pledged to secure U.S. Treasury borrowings, public deposits, securities sold under agreements to repurchase, and for other purposes required by law.

Gross unrealized losses on investment securities available for sale and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in continuous unrealized loss position, at March 31, 2013, were as follows:

	Less Than 12 Months				12 Months or More				Total
(In thousands)	Fair Value		Loss		Fair Value		Loss			Fair Value	Loss
U.S. Agency Obligations	$	20,751	$	173	$	0	$	0	$	20,751	$	173
U.S. GSEs		14,788		164		0		0		14,788		164
FHLB Obligations		19,894		106		0		0		19,894		106
Agency MBSs		4,943		11		0		0		4,943		11
Agency CMBSs		9,875		87		0		0		9,875		87
Agency CMOs		69,028		640		0		0		69,028		640
CLOs		24,750		49		0		0		24,750		49
	$	164,029	$	1,230	$	0	$	0	$	164,029	$	1,230

Gross unrealized losses on investment securities available for sale and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in continuous unrealized loss position, at December 31, 2012, were as follows:

	Less Than 12 Months				12 Months or More				Total
(In thousands)	Fair Value		Loss		Fair Value		Loss		Fair Value		Loss
U.S. Agency Obligations	$	10,897	$	59	$	0	$	0	$	10,897	$	59
U.S. GSEs		9,882		88		0		0		9,882		88
Agency CMBSs		5,029		58		0		0		5,029		58
Agency CMOs		39,047		338		0		0		39,047		338
Non-agency CMOs		0		0		3,041		2		3,041		2
CLOs		24,527		221		0		0		24,527		221
	$	89,382	$	764	$	3,041	$	2	$	92,423	$	766

There were no securities held to maturity with unrealized losses as of March 31, 2013 or December 31, 2012.

There were no securities classified as trading at March 31, 2013 and December 31, 2012.

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

Agency MBSs and Agency CMOs consist of pools of residential mortgages which are guaranteed by the FNMA, FHLMC, or Government National Mortgage Association (“GNMA”) with various origination dates and maturities.  Agency CMBS consists of bonds backed by commercial real estate which are guaranteed by FNMA. CLOs are floating rate securities that consist of pools of commercial loans structured to provide very strong over collateralization and subordination.  All of our CLOs are the senior AAA tranche and are the first bond to get paid down. Non-Agency CMOs are tracked individually with updates on the performance of the

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underlying collateral and stress testing performed and reviewed monthly. Both of our non-agency CMOs held at March 31, 2013 were sold in early April for small gains. Additionally, we monitor individual bonds that experience greater levels prepayment or market volatility.

We use an external pricing service to obtain fair market values for our investment portfolio. We have obtained and reviewed the service provider’s pricing and reference data document. Evaluations are based on market data and vary by asset class and incorporate available trade, bid and other market information. Because many fixed income securities do not trade on a daily basis, the service provider’s evaluated pricing applications apply available information as applicable through processes such as benchmark curves, benchmarking of like securities, sector groupings, and matrix pricing, to prepare evaluations. In addition, model processes, such as the Option Adjusted Spread model are used to assess interest rate impact and develop prepayment scenarios. We periodically test the values provided to us by the pricing service through a combination of back testing on actual sales of securities and by obtaining prices on all bonds from an alternative pricing source.

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

As a member of the FHLB system, we are required to invest in stock of the Federal Home Loan Bank of Boston (“FHLBB”) in an amount determined based on our borrowings from the FHLBB. At March 31, 2013, our investment in FHLBB stock totaled $7.50 million. We received and recorded dividend income totaling $5 thousand and $17 thousand during the three months ended March 31, 2013 and 2012, respectively.

NOTE 4: LOANS AND THE ALLOWANCE FOR CREDIT LOSSES

Loans

The composition of our loan portfolio at March 31, 2013 and December 31, 2012 was as follows:

(In thousands)	March 31, 2013		December 31, 2012
Commercial, financial and agricultural	$	168,500	$	165,023
Municipal loans		85,211		84,689
Real estate loans – residential		504,226		489,951
Real estate loans – commercial		324,208		327,622
Real estate loans – construction		14,115		10,561
Installment loans		5,192		4,701
All other loans		261		376
Total loans	$	1,101,713	$	1,082,923

We primarily originate residential real estate, commercial, commercial real estate, municipal obligations and installment loans to customers throughout the state of Vermont. There are no significant industry concentrations in the loan portfolio. Total loans in the table above included $272 thousand and $250 thousand of net deferred loan origination cost at March 31, 2013 and December 31, 2012, respectively. The aggregate amount of overdrawn deposit balances classified as loan balances was $261 thousand and $376 thousand at March 31, 2013 and December 31, 2012, respectively.

Allowance for Credit Losses

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

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

Municipal: Municipal loans primarily consist of term and time loans issued on a tax-exempt and taxable basis which are general obligations of the municipality. These loans are viewed as lower risk as municipalities can utilize taxing power to meet financial obligations.

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

Real Estate – Commercial: We offer commercial real estate loans to finance real estate purchases and refinancing of existing commercial properties. These commercial real estate loans are generally secured by first liens on the real estate, which may include both owner occupied and non owner occupied facilities. The types of facilities financed include apartments, hotels, warehouses, retail facilities, manufacturing facilities and office buildings. Our underwriting analysis includes credit verification, independent appraisals, a review of the borrower's financial condition, and a detailed analysis of the borrower’s underlying cash flows.

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

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

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

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

The following table reflects our loan loss experience and activity in the allowance for credit losses by portfolio segment for the three months ended March 31, 2013:

(In thousands)	Commercial, financial and agricultural		Municipal		Real estate- residential		Real estate- commercial		Real estate-construction		Installment		All other		Totals
Allowance for credit losses:
Beginning balance	$	3,447	$	522	$	3,582	$	4,499	$	234	$	17	$	11	$	12,312
Charge-offs		0		0		(7)		(1)		0		0		(20)		(28)
Recoveries		9		0		3		40		1		0		1		54
Provision (credit)		(45)		133		130		(27)		40		(1)		20		250
Ending balance	$	3,411	$	655	$	3,708	$	4,511	$	275	$	16	$	12	$	12,588

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The following table reflects our loan loss experience and activity in the allowance for credit losses by portfolio segment for the three months ended March 31, 2012:

(In thousands)	Commercial, financial and agricultural		Municipal		Real estate- residential		Real estate- commercial		Real estate-construction		Installment		All other		Totals
Allowance for credit losses:
Beginning balance	$	2,905	$	309	$	3,138	$	4,484	$	477	$	23	$	17	$	11,353
Charge-offs		0		0		0		0		0		0		0		0
Recoveries		20		0		1		1		7		0		0		29
Provision (credit)		(192)		233		235		199		(204)		(5)		(16)		250
Ending balance	$	2,733	$	542	$	3,374	$	4,684	$	280	$	18	$	1	$	11,632

The allowance for credit losses consists of the allowance for loan losses and the reserve for undisbursed lines of credit. The reserve for undisbursed lines of credit is included in other liabilities on the balance sheet. The following presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment based upon impairment method at March 31, 2013:

(In thousands)	Commercial, financial and agricultural		Municipal		Real estate- residential		Real estate- commercial		Real estate-construction		Installment		All other		Totals
Allowance for credit losses:
Ending balance individually evaluated for impairment	$	126	$	0	$	491	$	58	$	0	$	3	$	0	$	678
Ending balance collectively evaluated for impairment		3,285		655		3,217		4,453		275		13		12		11,910
Totals	$	3,411	$	655	$	3,708	$	4,511	$	275	$	16	$	12	$	12,588
Financing receivables:
Ending balance individually evaluated for impairment	$	724	$	0	$	2,401	$	281	$	0	$	9	$	0	$	3,415
Ending balance collectively evaluated for impairment		167,776		85,211		501,825		323,927		14,115		5,183		261		1,098,298
Totals	$	168,500	$	85,211	$	504,226	$	324,208	$	14,115	$	5,192	$	261	$	1,101,713
Components:
Allowance for loan losses	$	2,829	$	648	$	3,621	$	4,452	$	218	$	16	$	12	$	11,796
Reserve for undisbursed lines of credit		582		7		87		59		57		0		0		792
Total allowance for credit losses	$	3,411	$	655	$	3,708	$	4,511	$	275	$	16	$	12	$	12,588

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The following presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment based upon impairment method at December 31, 2012:

(In thousands)	Commercial, financial and agricultural		Municipal		Real estate- residential		Real estate- commercial		Real estate-construction		Installment		All other		Totals
Allowance for credit losses:
Ending balance individually evaluated for impairment	$	149	$	0	$	361	$	59	$	0	$	0	$	0	$	569
Ending balance collectively evaluated for impairment		3,298		522		3,221		4,440		234		17		11		11,743
Totals	$	3,447	$	522	$	3,582	$	4,499	$	234	$	17	$	11	$	12,312
Financing receivables:
Ending balance individually evaluated for impairment	$	233	$	0	$	2,317	$	472	$	0	$	0	$	0	$	3,022
Ending balance collectively evaluated for impairment		164,790		84,689		487,634		327,150		10,561		4,701		376		1,079,901
Totals	$	165,023	$	84,689	$	489,951	$	327,622	$	10,561	$	4,701	$	376	$	1,082,923
Components:
Allowance for loan losses	$	2,915	$	494	$	3,494	$	4,444	$	187	$	17	$	11	$	11,562
Reserve for undisbursed lines of credit		532		28		88		55		47		0		0		750
Total allowance for credit losses	$	3,447	$	522	$	3,582	$	4,499	$	234	$	17	$	11	$	12,312

The table below presents the recorded investment of loans, including nonaccrual and restructured loans, segregated by class, with delinquency aging as of March 31, 2013:

	30-59 Days		60-89 Days		90 Days or More		Total Past						Greater Than 90 Days and
(In thousands)	Past Due		Past Due		Past Due		Due		Current		Total		Accruing
Commercial, financial and agricultural	$	818	$	0	$	0	$	818	$	167,682	$	168,500	$	0
Municipal		0		0		0		0		85,211		85,211		0
Real estate-residential:
First mortgage		101		163		974		1,238		465,805		467,043		0
Second mortgage		80		0		716		796		36,387		37,183		0
Real estate-commercial:
Owner occupied		68		0		107		175		221,175		221,350		0
Non-owner occupied		0		74		0		74		102,784		102,858		0
Real estate-construction:
Residential		0		0		0		0		1,859		1,859		0
Commercial		0		0		0		0		12,256		12,256		0
Installment		1		0		0		1		5,191		5,192		0
Other		0		0		0		0		261		261		0
Total	$	1,068	$	237	$	1,797	$	3,102	$	1,098,611	$	1,101,713	$	0

Out of the $4.21 million in past due loans above $2.12 million are non-accruing or restructured.

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The table below presents the recorded investment of loans, including nonaccrual and restructured loans, segregated by class, with delinquency aging as of December 31, 2012:

	30-59 Days		60-89 Days		90 Days or More		Total Past						Greater Than 90 Days and
	Past Due		Past Due		Past Due		Due		Current		Total		Accruing
Commercial, financial and agricultural	$	0	$	0	$	0	$	0	$	165,023	$	165,023	$	0
Municipal		0		0		0		0		84,689		84,689		0
Real estate-residential:
First mortgage		92		43		950		1,085		449,956		451,041		0
Second mortgage		0		0		716		716		38,194		38,910		0
Real estate-commercial:
Owner occupied		0		0		295		295		222,013		222,308		0
Non-owner occupied		0		0		0		0		105,314		105,314		0
Real estate-construction:
Residential		0		0		0		0		1,559		1,559		0
Commercial		0		0		0		0		9,002		9,002		0
Installment		0		0		0		0		4,701		4,701		0
Other		0		0		0		0		376		376		0
Total	$	92	$	43	$	1,961	$	2,096	$	1,080,827	$	1,082,923	$	0

All of the total past due loans in the aging table above consist of non-accruing and restructured loans. There were no past due performing loans at December 31, 2012.

Impaired loans by class at March 31, 2013 are as follows:

(In thousands)	Recorded Investment		Unpaid Principal Balance		Related Allowance
With no related allowance recorded
Commercial, financial and agricultural	$	306	$	1,244	$	0
Real estate – residential:
First mortgage		836		1,237		0
Second mortgage		171		207		0
Real estate – commercial:
Owner occupied		107		243		0
Non-owner occupied		0		70		0
Installment		0		44		0
With related allowance recorded
Commercial, financial and agricultural		418		435		126
Real estate – residential:
First mortgage		694		702		154
Second mortgage		700		700		337
Real estate – commercial:
Owner occupied		174		178		58
Installment		9		10		3
Total
Commercial, financial and agricultural		724		1,679		126
Real estate – residential		2,401		2,846		491
Real estate – commercial		281		491		58
Installment		9		54		3
Total	$	3,415	$	5,070	$	678

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Impaired loans by class at December 31, 2012 are as follows:    

(In thousands)	Recorded Investment		Unpaid Principal Balance		Related Allowance
With no related allowance recorded
Commercial, financial and agricultural	$	7	$	970	$	0
Real estate – residential:
First mortgage		853		1,174		0
Second mortgage		16		52		0
Real estate – commercial:
Owner occupied		295		487		0
Non-owner occupied		0		70		0
Installment		0		45		0
With related allowance recorded
Commercial, financial and agricultural		226		228		149
Real estate – residential:
First mortgage		748		766		173
Second mortgage		700		700		188
Real estate – commercial:
Owner occupied		177		179		59
Non-owner occupied
Total
Commercial, financial and agricultural		233		1,198		149
Real estate – residential		2,317		2,692		361
Real estate – commercial		472		736		59
Installment		0		45		0
Total	$	3,022	$	4,671	$	569

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Average recorded investment and interest income recognized on our impaired loans for the periods indicated is presented below:

	Three Months Ended March 31, 2013				Three Months Ended March 31, 2012
(In thousands)	Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded
Commercial, financial and agricultural	$	107	$	8	$	70	$	7
Real estate – residential:
First mortgage		841		33		818		14
Second mortgage		67		0		199		0
Real estate – commercial:
Owner occupied		36		15		335		1
Non-owner occupied		0		0		0		0
Installment		3		0		0		0
With related allowance recorded
Commercial, financial and agricultural		414		0		30		0
Real estate – residential:
First mortgage		677		0		783		0
Second mortgage		700		0		84		0
Real estate – commercial:
Owner occupied		174		0		108		0
Installment		3		0		0		0
Total
Commercial, financial and agricultural		521		8		100		7
Real estate – residential		2,285		33		1,884		14
Real estate – commercial		210		15		443		1
Installment		6		0		0		0
Total	$	3,022	$	56	$	2,427	$	22

There was no interest recognized on a cash basis for either period in the table above.

Nonperforming loans at March 31, 2013 and December 31, 2012 are as follows:

(In thousands)	March 31, 2013		December 31, 2012
Nonaccrual  loans	$	2,876	$	2,355
Loans greater than 90 days and accruing		0		0
TDRs		539		557
Total nonperforming loans	$	3,415	$	2,912

Of the total TDRs in the table above, $363 thousand at March 31, 2013 and $374 thousand at December 31, 2012, are nonaccruing.

We have reviewed all restructurings that occurred on or after January 1, 2013 for identification as troubled debt restructurings. We did not identify as TDR any loans for which the allowance for credit losses had been measured under a general allowance for credit losses methodology. The loans in the table below are considered impaired under the guidance in Section 310-10-35 of the FASB codification.  All of the TDRs as of March 31, 2013 were restructured prior to January 1, 2013.

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Presented below is a summary of our restructurings during the three months ended March 31, 2013 and March 31, 2012. There were no TDRs during the three months ended March 31, 2013.

	Three Months Ended March 31, 2013					Three Months Ended March 31, 2012
	Number	Pre-Modification Recorded		Post-Modification Recorded		Number	Pre-Modification Recorded		Post-Modification Recorded
(Dollars in thousands)	of Loans	Investment		Investment		of Loans	Investment		Investment
Real estate – residential:
First mortgage	0	$	0	$	0	1	$	182	$	182

Modifications were granted which consisted of lower interest rates and more favorable payment terms to the borrower. There were no TDRs restructured within the past twelve months that have defaulted.

There were ten TDRs at March 31, 2013, all of which demonstrated cash flow insufficient to service their debt, as well as an inability to obtain funds at market rates from other sources. At March 31, 2013, one restructured loan totaling $50 thousand that was restructured in a prior year, was in default with foreclosure proceedings in process. The other loans were performing in accordance with their modified agreements. At March 31, 2013, four of the loans totaling $176 thousand were accruing and six of the loans totaling $363 thousand were in nonaccrual. At March 31, 2013, there were no commitments to lend additional funds to borrower whose loans have been modified in a troubled debt restructuring. We had $44 thousand in commitments to lend additional funds to borrowers whose loans were in nonaccrual status or to borrowers whose loans were 90 days past due and still accruing. Merchants recorded interest income on restructured loans of approximately $2 thousand during the three months ended March 31, 2013 and $4 thousand during the three months ended March 31, 2012.

We had no OREO at March 31, 2013 or at December 31, 2012.

Nonaccrual loans by class as of March 31, 2013 and December 31, 2012 are as follows:

(In thousands)	March 31, 2013		December 31, 2012
Commercial, financial and agricultural	$	719	$	225
Real estate - residential:
First mortgage		1,170		1,119
Second mortgage		871		716
Real estate - commercial:
Owner occupied		107		295
Non owner occupied		0		0
Installment		9		0
Total nonaccruing non-TDR loans	$	2,876	$	2,355
Nonaccruing TDR’s
Commercial, financial and agricultural		5		8
Real estate – residential:
First mortgage		184		189
Real estate - commercial:
Owner occupied		174		177
Total nonaccrual loans including TDRs	$	3,239	$	2,729

Commercial Grading System

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

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

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

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

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

Residential  real estate and consumer loans

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

Below is a summary of loans by credit quality indicator as of March 31, 2013:

	Unrated Residential and				Pass-		Special		Sub-
(In thousands)	Consumer		Pass		Watch		Mention		Standard		Total
Commercial, financial and agricultural	$	77	$	143,900	$	18,059	$	637	$	5,827	$	168,500
Municipal		0		76,353		8,858		0		0		85,211
Real estate – residential:
First mortgage		433,736		30,250		1,216		191		1,650		467,043
Second mortgage		35,473		1,000		0		0		710		37,183
Real estate – commercial:
Owner occupied		94		179,727		17,188		7,074		17,267		221,350
Non-owner occupied		49		90,219		10,578		608		1,404		102,858
Real estate – construction:
Residential		340		0		1,519		0		0		1,859
Commercial		585		11,154		517		0		0		12,256
Installment		5,192		0		0		0		0		5,192
All other loans		261		0		0		0		0		261
Total	$	475,807	$	532,603	$	57,935	$	8,510	$	26,858	$	1,101,713

Below is a summary of loans by credit quality indicator as of December 31, 2012:

	Unrated Residential and				Pass-		Special		Sub-
(In thousands)	Consumer		Pass		Watch		Mention		Standard		Total
Commercial, financial and agricultural	$	85	$	138,307	$	18,738	$	5,704	$	2,189	$	165,023
Municipal		5		77,242		7,442		0		0		84,689
Real estate – residential:
First mortgage		418,802		29,237		1,275		194		1,533		451,041
Second mortgage		37,200		1,000		0		0		710		38,910
Real estate – commercial:
Owner occupied		86		188,330		16,718		3,546		13,628		222,308
Non-owner occupied		40		93,002		10,211		613		1,448		105,314
Real estate – construction:
Residential		41		0		1,518		0		0		1,559
Commercial		598		7,882		522		0		0		9,002
Installment		4,701		0		0		0		0		4,701
All other loans		376		0		0		0		0		376
Total	$	461,934	$	535,000	$	56,424	$	10,057	$	19,508	$	1,082,923

The amount of interest which was not earned, but which would have been earned had our nonaccrual and restructured loans performed

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in accordance with their original terms and conditions, was approximately $44 thousand and $55 thousand for the three months ended March 31, 2013 and 2012, respectively.

NOTE 5: EMPLOYEE BENEFIT PLANS

Pension Plan

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

The following tables summarize the components of net periodic benefit cost and other changes in Pension Plan assets and benefit obligations recognized in other comprehensive income for the three months ended March 31, 2013 and 2012, respectively:

(In thousands)		2013		2012
Interest cost	$	104	$	109
Expected return on plan assets		(247)		13
Service costs		15		(144)
Net loss amortization		92		101
Net periodic pension cost	$	(36)	$	79

We have no minimum required contribution for 2013.

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

NOTE 6: EARNINGS PER SHARE

The following table presents reconciliations of the calculations of basic and diluted earnings per share for the three months ended March 31, 2013 and 2012:

(In thousands except per share data)	2013		2012
Net income	$	3,609	$	3,613
Weighted average common shares outstanding		6,287		6,237
Dilutive effect of common stock equivalents		12		15
Weighted average common and common equivalent
shares outstanding		6,299		6,252
Basic earnings per common share	$	0.57	$	0.58
Diluted earnings per common share	$	0.57	$	0.58

Basic earnings per common share were computed by dividing net income by the weighted average number of shares of common stock outstanding for the three months ended March 31, 2013 and 2012. The computation of diluted earnings per share excludes the effect of assuming the exercise of certain outstanding stock options because the effect would be anti-dilutive. There were no anti-dilutive options outstanding for the three months ended March 31, 2013 or 2012, which were not considered in the calculation of diluted earnings per share because the stock options’ exercise price was greater than the average market price during these periods.

NOTE 7: STOCK REPURCHASE PROGRAM

We extended, through January 2014, our stock buyback program, originally adopted in January 2007. Under the program we may repurchase up to 200,000 shares of our common stock on the open market from time to time, and have purchased 143,475 shares at an average price per share of $22.94 since the program’s adoption. We did not repurchase any of our shares during 2012 or during the first three months of 2013, and do not expect to repurchase shares in the near future.

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NOTE 8: COMMITMENTS AND CONTINGENCIES

Financial Instruments with Off-Balance Sheet Risk

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

Disclosures are required regarding liability-recognition for the fair value at issuance of certain guarantees. We do not issue any guarantees that would require liability-recognition or disclosure, other than our standby letters of credit. We have issued conditional commitments in the form of standby letters of credit to guarantee payment on behalf of a customer and guarantee the performance of a customer to a third party. Standby letters of credit generally arise in connection with lending relationships. The credit risk involved in issuing these instruments is essentially the same as that involved in extending loans to customers. Contingent obligations under standby letters of credit totaled approximately $4.71 million and $4.48 million at March 31, 2013 and December 31, 2012, respectively, and represent the maximum potential future payments we could be required to make. Typically, these instruments have terms of 12 months or less and expire unused; therefore, the total amounts do not necessarily represent future cash requirements. Each customer is evaluated individually for creditworthiness under the same underwriting standards used for commitments to extend credit and on-balance sheet instruments. Our policies governing loan collateral apply to standby letters of credit at the time of credit extension. Loan-to-value ratios are generally consistent with loan-to-value requirements for other commercial loans secured by similar types of collateral.

We may enter into commitments to sell loans, which involve market and interest rate risk. There were no such commitments at March 31, 2013 or December 31, 2012.

Legal Proceedings

We have been named as defendants in various legal proceedings arising from our normal business activities. Although the amount of any ultimate liability with respect to such proceedings cannot be determined, in the opinion of Management, based upon input from counsel on the outcome of such proceedings, any such liability will not have a material effect on our financial condition and results of operations.

NOTE 9: FAIR VALUE OF FINANCIAL INSTRUMENTS

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

Our valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. While Management believes our valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date. Furthermore, the reported fair value amounts have not been comprehensively revalued since the presentation dates, and therefore, estimates of fair value after the balance sheet date may differ significantly from the amounts presented herein.  A more detailed description of the valuation methodologies used for assets and liabilities measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below.

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

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

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

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

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

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Financial instruments on a recurring basis

The table below presents the balance of financial assets and liabilities at March 31, 2013 measured at fair value on a recurring basis:

			Fair Value Measurements at Reporting Date Using
			Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
(In thousands)	Total		(Level 1)		(Level 2)		(Level 3)
Assets
U.S. Treasury Obligations	$	100	$	0	$	100	$	0
U.S. Agency Obligations		25,811		0		25,811		0
U.S. GSEs		46,589		0		46,589		0
FHLB Obligations		22,441		0		22,441		0
Agency MBSs		135,853		0		135,853		0
Agency CMBSs		18,690		0		18,690		0
Agency CMOs		226,970		0		226,970		0
Non-Agency CMOs		4,375		0		4,375		0
CLOs		26,750		0		26,750		0
ABSs		415		0		415		0
Interest rate swap agreements		478		0		478		0
Total assets	$	508,472	$	0	$	508,472	$	0
Liabilities
Interest rate swap agreements		1,461		0		1,461		0
Total liabilities	$	1,461	$	0	$	1,461	$	0

The table below presents the balance of financial assets and liabilities at December 31, 2012 measured at fair value on a recurring basis:

			Fair Value Measurements at Reporting Date Using
			Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
(In thousands)	Total		(Level 1)		(Level 2)		(Level 3)
Assets
U.S. Treasury Obligations	$	100	$	0	$	100	$	0
U.S. Agency Obligations		10,897		0		10,897		0
U.S. GSEs		59,366		0		59,366		0
FHLB Obligations		24,585		0		24,585		0
Agency MBSs		148,767		0		148,767		0
Agency CMBSs		5,029		0		5,029		0
Agency CMOs		230,399		0		230,399		0
Non-Agency CMOs		4,593		0		4,593		0
CLOs		24,527		0		24,527		0
ABSs		418		0		418		0
Interest rate swap agreements		552		0		552		0
Total assets	$	509,233	$	0	$	509,233	$	0
Liabilities
Interest rate swap agreements		1,610		0		1,610		0
Total liabilities	$	1,610	$	0	$	1,610	$	0

Investment securities are reported at fair value utilizing Level 2 inputs. The prices for these instruments are obtained through an independent pricing service or dealer market participant with whom we have historically transacted both purchases and sales of investment securities. Prices obtained from these sources include market quotations and matrix pricing. The fair value measurements

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consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things. More information regarding our investment securities can be found in Footnote 3 to these consolidated financial statements.

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

There were no transfers between Level 1 and Level 2 for the three months ended March 31, 2013 or March 31, 2012.  There were no Level 3 assets measured at fair value on a recurring basis during the three months ended March 31, 2013.

Financial instruments on a non-recurring basis

Certain assets are also measured at fair value on a non-recurring basis. These other financial assets include impaired loans and OREO.

The table below presents the balance of financial assets by class at March 31, 2013 measured at fair value on a nonrecurring basis:

			Fair Value Measurements at Reporting Date Using
			Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
(In thousands)	Total		(Level 1)		(Level 2)		(Level 3)
Commercial, financial and agricultural	$	309	$	0	$	0	$	309
Real estate-residential:
First mortgage		548		0		0		548
Second mortgage		363		0		0		363
Real estate-commercial:
Owner occupied		120		0		0		120
Installment		7		0		0		7
Total	$	1,347	$	0	$	0	$	1,347

The table below presents the balance of financial assets by class at December 31, 2012 measured at fair value on a nonrecurring basis:

			Fair Value Measurements at Reporting Date Using
			Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
(In thousands)	Total		(Level 1)		(Level 2)		(Level 3)
Commercial, financial and agricultural	$	79	$	0	$	0	$	79
Real estate-residential:
First mortgage		593		0		0		593
Second mortgage		512		0		0		512
Real estate-commercial:
Owner occupied		415		0		0		415
Total	$	1,599	$	0	$	0	$	1,599

We use the fair value of underlying collateral to estimate the specific reserves for collateral dependent impaired loans. Collateral may be real estate and/or business assets including equipment, inventory and accounts receivable. Real estate values are determined based on appraisals by qualified licensed appraisers we have hired. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Management’s ongoing review of appraisal information may result in additional discounts or adjustments to valuation based upon more recent market sales activity or more current appraisal information derived from properties of similar type and/or locale. Other business assets are valued using a variety of approaches including appraisals, depreciated book value, purchase price and independent confirmation of accounts receivable. Property acquired is carried at the lower of cost or the estimated fair value of the property, determined by an independent appraisal, and is adjusted for estimated disposal costs. Certain inputs used in appraisals, and possible subsequent adjustments, are not always observable, and therefore, collateral dependent impaired loans and OREO are categorized as Level 3 within the fair value hierarchy.

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The table below presents the valuation methodology and unobservable inputs for Level 3 assets by class measured at fair value on a non-recurring basis at March 31, 2013:

					Range of
(Dollars in thousands)	Fair value		Valuation Methodology	Unobservable Inputs	Inputs
Commercial, financial and agricultural	$	309	Appraisal of collateral	Appraisal adjustments	0%-40%
Real estate-residential:
First mortgage		548	Appraisal of collateral	Appraisal adjustments	0%-40%
Second mortgage		363	Appraisal of collateral	Appraisal adjustments	0%-40%
Real estate-commercial:
Owner occupied		120	Appraisal of collateral	Appraisal adjustments	0%-40%
Installment		7	Appraisal of collateral	Appraisal adjustments	0%-40%
Total	$	1,347

The table below presents the valuation methodology and unobservable inputs for Level 3 assets by class measured at fair value on a non-recurring basis at December 31, 2012:

					Range of
(Dollars in thousands)	Fair value		Valuation Methodology	Unobservable Inputs	Inputs
Commercial, financial and agricultural	$	79	Appraisal of collateral	Appraisal adjustments	0%-40%
Real estate-residential:
First mortgage		593	Appraisal of collateral	Appraisal adjustments	0%-40%
Second mortgage		512	Appraisal of collateral	Appraisal adjustments	0%-40%
Real estate-commercial:
Owner occupied		415	Appraisal of collateral	Appraisal adjustments	0%-40%
Total	$	1,599

Changes to our assumptions about unobservable inputs will impact our estimate of fair value.  Discounts to appraised values reflect the age of the appraisal and estimated costs of disposition.

GAAP requires disclosure of the fair value of financial assets and financial liabilities, including those financial assets and financial liabilities that are not measured and reported at fair value on a recurring or non-recurring basis.

The fair value of Merchants’ financial instruments as of March 31, 2013 are summarized in the table below:

	Carrying
(In thousands)	Amount		Fair Value			Level 1		Level 2		Level 3
Cash and cash equivalents	$	43,023	$	43,023	$	43,023	$	0	$	0
Securities available for sale		507,994		507,994		0		507,994		0
Securities held to maturity		366		403		0		403		0
FHLB stock		7,496		7,496		0		7,496		0
Loans, net of allowance for loan losses		1,089,917		1,106,770		0		0		1,106,770
Interest rate contract-cash flow hedge		478		478		0		478		0
Accrued interest receivable		5,280		5,280		0		1,454		3,826
Total assets	$	1,654,554	$	1,671,444	$	43,023	$	517,825	$	1,110,596
Deposits	$	1,269,777	$	1,272,021	$	934,681	$	337,340	$	0
Short-term borrowings		30,900		30,900		0		30,900		0
Securities sold under agreement to repurchase		243,204		243,371		0		243,371		0
Other long-term debt		2,463		2,468		0		2,468		0
Junior subordinated debentures issued to unconsolidated subsidiary trust		20,619		15,449		0		15,449		0
Interest rate contract-cash flow hedge		1,461		1,461		0		1,461		0
Accrued interest payable		191		191		0		191		0
Total liabilities	$	1,568,615	$	1,565,861	$	934,681	$	631,180	$	0

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The fair value of Merchants’ financial instruments as of December 31, 2012 are summarized in the table below:

	Carrying
(In thousands)	Amount		Fair Value			Level 1		Level 2		Level 3
Cash and cash equivalents	$	77,228	$	77,228	$	77,228	$	0	$	0
Securities available for sale		508,681		508,681		0		508,681		0
Securities held to maturity		407		454		0		454	��	0
FHLB stock		8,145		8,145		0		8,145		0
Loans, net of allowance for loan losses		1,071,361		1,096,188		0		0		1,096,188
Interest rate contract-cash flow hedge		552		552		0		552		0
Accrued interest receivable		4,368		4,368		0		1,366		3,002
Total assets	$	1,670,742	$	1,695,616	$	77,228	$	519,198	$	1,099,190
Deposits	$	1,271,080	$	1,273,573	$	940,682	$	332,891	$	0
Short-term borrowings		0		0		0		0		0
Securities sold under agreement to repurchase		287,520		287,837		0		287,837		0
Other long-term debt		2,483		2,502		0		2,502		0
Junior subordinated debentures issued to unconsolidated subsidiary trust		20,619		15,177		0		15,177		0
Interest rate contract-cash flow hedge		1,610		1,610		0		1,610		0
Accrued interest payable		195		195		0		195		0
Total liabilities	$	1,583,507	$	1,580,894	$	940,682	$	640,212	$	0

The carrying amounts reported in the consolidated balance sheets for cash and cash equivalents, FHLBB stock, accrued interest receivable and accrued interest payable approximate fair value.

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

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

Deposits - The fair value of demand deposits approximates the amount reported in the consolidated balance sheets. The fair value of variable rate, fixed term certificates of deposit also approximates the carrying amount reported in the consolidated balance sheets. The fair value of fixed rate and fixed term certificates of deposit is estimated using a discounted cash flow method which applies interest rates currently being offered for deposits of similar remaining maturities.

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

Commitments to Extend Credit and Standby Letters of Credit - The fair value of commitments to extend credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of financial standby letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties. The fair value of commitments to extend credit and standby letters of credit is approximately $47 thousand at March 31, 2013 and $45 thousand as of December 31, 2012, respectively.

Limitations ‑ Fair value estimates are made at a specific point in time based on relevant market information and information about the financial instruments.  Because no market exists for a significant portion of the financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other such factors.

These estimates do not reflect any premium or discount that could result from offering for sale at one time our entire holdings of a particular financial instrument.  These estimates are subjective in nature and require considerable judgment to interpret market data. Accordingly, the estimates presented herein are not necessarily indicative of the amounts we could realize in a current market exchange, nor are they intended to represent the fair value of us as a whole.  The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts.  The fair value estimates presented herein are based on pertinent information available to Management as of the respective balance sheet date.  Although we are not aware of any

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factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued since the presentation dates, and therefore, estimates of fair value after the balance sheet date may differ significantly from the amounts presented herein.

Other significant assets, such as premises and equipment, other assets, and liabilities not defined as financial instruments, are not included in the above disclosures.  Also, the fair value estimates for deposits do not include the benefit that results from the low-cost funding provided by the deposit liabilities compared to the cost of borrowing funds in the market.

NOTE 10: COMPREHENSIVE INCOME

The accumulated balances for each classification of other comprehensive income are as follows:

(In thousands)	Unrealized (Gains) Losses on Securities		Pension and Postretirement Benefit Plans		Interest Rate Swaps		Accumulated Other Comprehensive Income (Loss)
Balance December 31, 2012	$	6,033	$	(3,130)	$	(688)	$	2,215
Other comprehensive income before reclassifications		(1,285)		0		48		(1,237)
Reclassification adjustments for (gains) losses reclassified into income		0		60		0		60
Net current period other comprehensive (loss) income		(1,285)		60		48		(1,177)
Balance March 31, 2013	$	4,748	$	(3,070)	$	(640)	$	1,038

All amounts in the table above are net of tax. Amounts in parenthesis indicate debits.

NOTE 11: DERIVATIVE FINANCIAL INSTRUMENTS

At March 31, 2013 and December 31, 2012, we held an interest rate swap with a  notional amount of $10 million that was designated as  a cash flow hedge. The swap was used to convert a portion of the floating rate interest on our trust preferred issuance to a fixed rate of interest. The purpose of the hedge was to protect us from the risk of variability arising from the floating rate interest on the debentures. The effective portion of unrealized changes in the fair value of derivatives accounted for as cash flow hedges are reported in other comprehensive income and reclassified to earnings if gains or losses are realized. Each quarter we assess the effectiveness of the hedging relationships by comparing the changes in cash flows of the derivative hedging instruments with the changes in cash flows of the designated hedged item. The ineffective portion of changes in the fair value of the derivatives is recognized directly in earnings. There was no ineffective portion recognized in earnings during the first quarter of 2013 or 2012. The fair value of $(983) thousand and $(1.06) million was reflected in other comprehensive income in the accompanying consolidated balance sheets at March 31, 2013 and December 31, 2012, respectively.

At March 31, 2013 and December 31, 2012, we had two interest rate derivative positions, with a combined notional amount of $28.38 million and $28.63 million, respectively, that were not designated as hedging instruments. These derivative positions related to a transaction in which we entered into an interest rate swap with a customer while at the same time entering into an offsetting rate swap with another financial institution. In connection with the transaction, we agreed to pay interest to the customer on a notional amount at a variable interest rate and receive interest from the customer on the same notional amount at a fixed interest rate. At the same time, we agreed to pay another financial institution the same fixed interest rate on the same notional amount and receive the same variable interest rate on the same notional amount. The transaction allows our customer to effectively convert a variable rate loan to a fixed rate loan. Because the terms of the swaps with our customer and the other financial institution offset each other, with the only difference being counterparty credit risk, changes in the fair value of the underlying derivative contracts are not materially different and do not significantly impact our results of operations. The fair value was reflected in other assets and other liabilities in the accompanying consolidated balance sheets at March 31, 2013. We assessed our counterparty risk at March 31, 2013 and determined any credit risk inherent in our derivative contracts was insignificant. Information about the fair value of derivative financial instruments can be found in Footnote 9 to these consolidated financial statements.

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

FORWARD-LOOKING STATEMENTS 

Certain statements contained in this Quarterly Report on Form 10-Q that are not historical facts may constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and are intended to be covered by the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements involve risks and uncertainties. These statements, which are based on certain assumptions and describe our future plans, strategies and expectations, can generally be identified by the use of the words “may,” “will,” “should,” “could,” “would,” “plan,” “potential,” “estimate,” “project,” “believe,” “intend,” “anticipate,” “expect,” “target” and similar expressions. Forward-looking statements are based on the current assumptions and beliefs of Management and are only expectations of future results. Our actual results could differ materially from those projected in the forward-looking statements as a result of, among others, continued weakness in general, national, regional or local economic conditions, which could impact the performance of our investment portfolio, quality of credits or the overall demand for services; changes in loan default and charge-off rates which could affect the allowance for credit losses; declines in the equity and financial markets; reductions in deposit levels which could necessitate increased and/or higher cost borrowing to fund loans and investments; declines in mortgage loan refinancing, equity loan and line of credit activity which could reduce net interest and noninterest income; changes in the domestic interest rate environment and inflation; changes in the carrying value of investment securities and other assets; further actions by the U.S. government and Treasury Department that could have a negative impact on our investment portfolio and earnings; misalignment of our interest-bearing assets and liabilities; increases in loan repayment rates affecting interest income; changing business, banking, or regulatory conditions or policies, or new legislation affecting the financial services industry, that could lead to changes in the competitive balance among financial institutions, restrictions on bank activities, changes in costs (including deposit insurance premiums), increased regulatory scrutiny, or changes in the secondary market for bank loan and other products; and changes in accounting rules, federal and state laws, IRS regulations, and other regulations and policies governing financial holding companies and their subsidiaries which may impact our ability to take appropriate action to protect our financial interests in certain loan situations.

Investors should not place undue reliance on our forward-looking statements, and are cautioned that forward-looking statements are inherently uncertain. Actual performance and results of operations may differ materially from those projected or suggested in the forward-looking statements due to certain risks and uncertainties, which are included in more detail in our Annual Report on Form 10-K, as updated by our Quarterly Reports on Form 10-Q, and other filings submitted to the Securities and Exchange Commission. We do not undertake any obligation to update any forward-looking statement to reflect circumstances or events that occur after the date the forward-looking statements are made.

USE OF NON-GAAP FINANCIAL MEASURES

Certain information in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contains financial information determined by methods other than in accordance with accounting principles generally accepted in the United States of America (“GAAP”).  We use these “non-GAAP” measures in our analysis of our performance and believe that these non-GAAP financial measures provide a greater understanding of ongoing operations and enhance comparability of results with prior periods as well as demonstrating the effects of significant gains and charges in the current period. We believe that a meaningful analysis of our financial performance requires an understanding of the factors underlying that performance. We believe that investors may use these non-GAAP financial measures to analyze financial performance without the impact of unusual items that may obscure trends in our underlying performance. These disclosures should not be viewed as a substitute for operating results determined in accordance with GAAP, nor are they necessarily comparable to non-GAAP performance measures that may be presented by other companies.

In several places net interest income is presented on a fully taxable equivalent basis. Specifically included in interest income is tax-exempt interest income from certain tax-exempt loans. An amount equal to the tax benefit derived from this tax exempt income is added back to the interest income total, to produce net interest income on a fully taxable equivalent basis. We believe the disclosure of taxable equivalent net interest income information improves the clarity of financial analysis, and is particularly useful to investors in understanding and evaluating the changes and trends in our results of operations. Other financial institutions commonly present net interest income on a taxable equivalent basis. This adjustment is considered helpful in the comparison of one financial institution’s net interest income to that of another, as each will have a different proportion of taxable exempt interest from its earning assets. Moreover, net interest income is a component of a second financial measure commonly used by financial institutions, net interest margin, which is the ratio of net interest income to average earning assets. For purposes of this measure as well, other financial institutions generally use taxable equivalent net interest income to provide a better basis of comparison from institution to institution. We follow these practices. A reconciliation of taxable equivalent financial information to our consolidated financial statements prepared in accordance with GAAP appears at the bottom of the table entitled “Distribution of Assets, Liabilities and Shareholders Equity; Interest Rates and Net Interest Margin.” A 35.0% tax rate was used in both 2013 and 2012.

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GENERAL

The following discussion and analysis of financial condition and results of operations of Merchants and its subsidiaries for the three months ended March 31, 2013 and 2012 should be read in conjunction with the consolidated financial statements and Notes thereto and selected statistical information appearing elsewhere in this Quarterly Report on Form 10-Q. The financial condition and results of operations of Merchants essentially reflect the operations of its principal subsidiary, Merchants Bank.

RESULTS OF OPERATIONS

Overview

We realized net income of  $3.61 million and $3.61 million for the three months ended March 31, 2013 and 2012, respectively. Basic and diluted earnings per share were $0.57 for the three months ended March 31, 2013 and $0.58 for the three months ended March 31, 2012. We declared and distributed total dividends of $0.28 per share during the three months ended 2013 and 2012.  On April 18, 2013, we declared a dividend of $0.28 per share, which will be paid on May 16, 2013, to shareholders of record as of May 2, 2013.  Total assets were $1.69 billion at March 31, 2013.  Total shareholders’ equity was $119.15 million at March 31, 2013, an increase of 0.8% over the balance at December 31, 2012.

Our return on average equity was 12.31% and 13.15% for the three months ended March 31, 2013 and 2012, respectively, and our return on average assets was 0.86% and 0.89% for 2013  and 2012, respectively. Book value per share increased to $18.94 during the first quarter of 2013. Our capital ratios remain strong, with a Tier 1 leverage ratio of 8.22%, a total risk-based capital ratio of 16.11% and a tangible capital ratio of 7.04%.

Ø Net interest income - Our taxable equivalent net interest income was $12.76 million for the three months ended March 2013 compared to $12.97 million for the same period in 2012.  Our taxable equivalent net interest margin decreased by 14 basis points for the first three months of 2013 to 3.20% from 3.34% for the first three months of 2012. 

Ø Provision for Credit Losses – The provision for credit losses was $250 thousand for the three months ended March 31, 2013 and 2012. Asset quality remained strong through the first quarter of 2013.   

Ø Loans - We also achieved a new record high in our loan portfolio. Ending loan balances at March 31, 2013 were $1.10 billion, an increase of $18.79 million, or 1.7%, from previous record balances of $1.08 billion at December 31, 2012. 

Ø Investments - Our investment portfolio totaled $508.36 million at March 31, 2013, a decrease of $728 thousand from the December 31, 2012 ending balance of $509.09 million.  

Ø Deposits – Deposit balances at March 31, 2013 were $1.27 billion, a decrease of $1.30 million from December 31, 2012 balances of $1.27 billion. 

Net Interest Income 

As shown on the accompanying schedule on page 29  our taxable equivalent net interest income was $12.76 million for the three months ended March 31, 2013, respectively, compared to $12.97 million for the same period in 2012 and $13.02 million for the fourth quarter of 2012. Our taxable equivalent net interest margin for the three months ended March 31, 2013 was unchanged from the fourth quarter of 2012 at 3.20%, and was 14 basis points lower than the first quarter of last year. Overall earning asset yields were two basis points lower for the first quarter of 2013 compared to the fourth quarter of 2012, and were 32 basis points lower for the first quarter of 2013 compared to the first quarter of 2012. This decrease results from a combination of reductions in average yields on both loans and investments. The decrease in asset yields was offset by a reduction in the cost of interest bearing liabilities.  The cost of interest bearing deposits decreased 10 basis points for the first quarter of 2013 compared to the same period in 2012, and decreased three basis points from the fourth quarter of 2012.  The cost of borrowed funds decreased 57 basis points for the first quarter of 2013 compared to the first quarter of 2012, and decreased seven basis points from the fourth quarter of 2012. The biggest change in our interest expense for the quarter was the expiration, on December 14, 2012, of an interest rate swap on $10 million of our Trust Preferred Securities (“TRUP”).  The expiration of the swap reduced our interest rate from a fixed rate of 6.50%, to a floating rate of three month LIBOR plus 1.95%. Interest expense on the entire $20 million TRUP was reduced to $184 thousand for the first quarter of 2013 compared to $276 thousand for the fourth quarter of 2012, and $295 thousand for the first quarter of 2012.

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The following table presents an analysis of net interest income and illustrates interest income earned and interest expense charged for each major component of interest earning assets and interest bearing liabilities. Yields/rates are computed on a fully taxable-equivalent (“FTE”) basis, using a 35% rate.  Nonaccrual loans are included in the average loan balance outstanding.

	Three Months Ended
	March 31, 2013			March 31, 2012
		Interest			Interest
	Average	Income/	Average	Average	Income/	Average
(In thousands, fully taxable equivalent)	Balance	Expense	Rate	Balance	Expense	Rate
ASSETS:
Loans, including fees on loans	$    1,086,289	$     11,266	4.21%	$  1,034,277	$    11,859	4.61%
Investments	511,842	2,785	2.21%	504,912	3,080	2.45%
Interest-earning deposits with banks and other short-term investments	18,442	12	0.26%	21,686	10	0.18%
Total interest earning assets	1,616,573	$     14,063	3.53%	1,560,875	$    14,949	3.85%
Allowance for loan losses	(11,689)			(10,736)
Cash and due from banks	25,469			21,332
Bank premises and equipment, net	16,286			14,364
Other assets	34,491			33,149
Total assets	$    1,681,130			$  1,618,984
LIABILITIES AND SHAREHOLDERS' EQUITY:
Interest-bearing deposits:
Savings, interest bearing checking and money market accounts	$       696,160	$          167	0.10%	$     640,937	$         226	0.14%
Time deposits	334,373	579	0.70%	347,791	734	0.85%
Total interest bearing deposits	1,030,533	746	0.29%	988,728	960	0.39%
Short-term borrowings	13,873	9	0.28%	22,703	14	0.25%
Securities sold under agreements to repurchase, short-term	264,884	348	0.53%	249,009	562	0.91%
Other long-term debt	2,470	12	2.02%	22,549	152	2.71%
Junior subordinated debentures issued to unconsolidated subsidiary trust	20,619	184	3.74%	20,619	295	5.83%
Total borrowed funds	301,846	553	0.74%	314,880	1,023	1.31%
Total interest bearing liabilities	1,332,379	$       1,299	0.40%	1,303,608	$      1,983	0.61%
Noninterest bearing deposits	223,245			195,425
Other liabilities	8,241			10,059
Shareholders' equity	117,265			109,892
Total liabilities and shareholders' equity	$    1,681,130			$  1,618,984
Net interest earning assets	$       284,194			$     257,267
Net interest income (fully taxable equivalent)		$     12,764			$    12,966
Tax equivalent adjustment		(482)			(530)
Net interest income		$     12,282			$    12,436
Net interest rate spread			3.13%			3.24%
Net interest margin			3.20%			3.34%

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

Analysis of Changes in Fully Taxable Equivalent Net Interest Income

	Three Months Ended
	March 31,		Increase	Due to
(In thousands)	2013	2012	(Decrease)	Volume	Rate
Fully taxable equivalent interest income:
Loans	$         11,266	$         11,859	$          (593)	$          537	$         (1,130)
Investments	2,785	3,080	(295)	38	(333)
Interest earning deposits with banks and other short-term investments	12	10	2	(1)	3
Total interest income	14,063	14,949	(886)	574	(1,460)
Less interest expense:
Savings, interest bearing checking and money market accounts	167	226	(59)	17	(76)
Time deposits	579	734	(155)	(28)	(127)
FHLB and other short-term borrowings	9	14	(5)	(4)	(1)
Securities sold under agreements to repurchase, short-term	348	562	(214)	33	(247)
Other long-term debt	12	152	(140)	(108)	(32)
Junior subordinated debentures issued to unconsolidated subsidiary trust	184	295	(111)	-	(111)
Total interest expense	1,299	1,983	(684)	(90)	(594)
Net interest income	$         12,764	$         12,966	$          (202)	$          664	$            (866)

Provision for Credit Losses

The allowance for loan losses at March 31, 2013 was $11.80 million, or 1.07% of total loans and 345% of non-performing loans compared to the December 31, 2012 balance of $11.56 million, or 1.07% of total loans and 397% of non-performing loans.  We recorded a provision of $250 thousand during the first quarter of 2013 and the first quarter of 2012.  Our asset quality remained strong during the first quarter of 2013. Our continued strong loan growth was the primary reason for the provision recorded during the quarter. Nonperforming loans were 0.31% of total loans, at March 31, 2013 compared to 0.27% of total loans, at December 31, 2012.  Net recoveries of previously charged-off loans for the three months ended March 31, 2013 were $26 thousand, compared to net recoveries of $29 thousand during the first quarter of 2012.  Performing loans past due 30-89 days were 0.09% of total loans at March 31, 2013, compared to zero at December 31, 2012.  Additionally, accruing substandard loans increased to 2.21% of total loans at March 31, 2013, compared to 1.60% at December 31, 2012.  Our other real estate owned (“OREO”) balance was zero at March 31, 2013 and December 31, 2012.  All of these factors are taken into consideration during Management’s quarterly review of the Allowance. For a more detailed discussion of our Allowance and nonperforming assets, see “Credit Quality and Allowance for Credit Losses” beginning on page 33.

NONINTEREST INCOME AND EXPENSES

Noninterest income

Total noninterest income increased $117 thousand to $2.48 million for the first quarter of 2013 compared to 2012. Excluding net gains (losses) on investment securities total noninterest income increased $193 thousand to $2.48 million for the first quarter of 2013 compared to $2.29 million for the first quarter of 2012.  Trust division income for the first quarter of 2013 increased $101 thousand to $758 thousand compared to the first quarter of 2012. Trust assets under management have continued to grow in 2013 and now total $577 million. Deposit service charges and cash management fees increased by $84 thousand for the first quarter of 2013 compared to the same period in 2012. This increase was offset almost entirely by a reduction in overdraft fees resulting in an overall $10 thousand increase in Service charges on deposits. The timing of investments in low income housing partnerships and their associated tax credits led to a reduction in equity in losses of real estate limited partnerships to $(270) thousand for the first quarter of 2013 from $(410) thousand for the first quarter of 2012. There was a related decrease in tax credits for the first quarter of 2013 compared to the first

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quarter of 2012, leading to an increase in our effective tax rate to 22.0% for the first quarter of 2013 from 18.7% for the first quarter of 2012.

Noninterest expense

Total noninterest expense decreased $219 thousand to $9.88 million for the first quarter of 2013 compared to the same period in 2012. Compensation and benefits decreased $393 thousand to $4.80 million for the first quarter of 2013 compared to the same period in 2012.  Salary increases were offset by increased vacancies and a lower incentive accrual. Additionally, the overfunded status of our pension plan has produced a $115 thousand swing in pension expense from a $79 thousand expense for the first quarter of 2012 to $36 thousand in income for the first quarter of 2013.

Income Taxes 

Our effective tax rate for the quarter ended March 31, 2012 was 22.0% compared to 18.7% for the first quarter of 2012. Our income tax provisions for these periods were less than the expense that would result from applying the federal statutory rate of 35% to income before income taxes principally because of the impact of federal affordable housing tax credits, historic rehabilitation credits and qualified school construction bond credits combined with tax exempt interest income on certain loans. The rate increase for the quarter ended March 31, 2013 compared to the quarter ended March 31, 2012 is due to a reduction in the amount of expected tax credits, combined with a reduction in total tax exempt income.

BALANCE SHEET ANALYSIS

Our balance sheet contracted slightly during the quarter.  Deposits and investments were essentially flat, while loans grew almost $19 million, funded by reductions in short term investment balances.  Seasonal reductions in collateralized customer accounts (securities sold under agreements to repurchase) were offset by increased short term borrowings from the Federal Home Loan Bank of Boston.

Loans

Average loans for the three months ended March 31, 2013 were $1.09 billion, a $52.01 million increase over average loans for 2012 of $1.03 billion.  Ending loan balances at March 31, 2013 reached a new record high of $1.10 billion, an increase of $18.79 million over ending loan balances at December 31, 2012.  This represents an annualized loan growth rate of 7%.

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

(In thousands)	March 31, 2013	December 31, 2012	March 31, 2012
Commercial, financial & agricultural	$ 168,500	$ 165,023	$ 146,660
Municipal	85,211	84,689	100,371
Real estate – residential	504,226	489,951	446,480
Real estate – commercial	324,208	327,622	330,873
Real estate – construction	14,115	10,561	11,884
Installment	5,192	4,701	4,411
All other loans	261	376	330
	$ 1,101,713	$ 1,082,923	$ 1,041,009

Growth in our commercial loan portfolio has been driven by new customer acquisition and expansion of existing relationships.  Growth in our residential real estate portfolio continues to be driven by increased mortgage refinance volume due to the low interest rate environment.

Investments

The investment portfolio is used to generate interest income, manage liquidity and mitigate interest rate sensitivity. Our investment portfolio totaled $508.36 million at March 31, 2013, a decrease of $728 thousand from the December 31, 2012 ending balance of $509.09 million.

We purchased bonds with a total book value of $40.80 million during the first quarter of 2013 and we  did not sell any bonds during the quarter.  These purchases were offset by calls and principal pay downs of a nearly equivalent amount.

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The composition of our investment portfolio as of March 31, 2013, including both held-to-maturity and available-for-sale securities, consisted of the following:

(In thousands)	Amortized Cost	Fair Value
Available for Sale:
U.S. Treasury Obligations	$ 100	$ 100
U.S. Agency Obligations	25,959	25,811
U.S. Government Sponsored Enterprises (“U.S. GSEs”)	46,144	46,589
FHLB Obligations	22,528	22,441
Residential Real Estate Mortgage-backed  Securities (“Agency MBSs”)	130,551	135,853
Agency Commercial Mortgage Backed Securities ("Agency CMBSs")	18,764	18,690
Agency Collateralized Mortgage Obligations (“Agency CMOs”)	225,112	226,970
Collateralized Loan Obligations ("CLOs")	26,799	26,750
Non-agency Collateralized Mortgage Obligations  (“Non-Agency CMOs”)	4,346	4,375
Asset Backed Securities (“ABSs”)	357	415
Total available for sale	500,660	507,994
Held to maturity:
Agency MBSs	366	403
Total held to maturity	366	403
Total Securities	$ 501,026	$ 508,397

Agency MBSs and Agency CMOs consist of pools of residential mortgages which are guaranteed by the FNMA, FHLMC, or Government National Mortgage Association (“GNMA”) with various origination dates and maturities.  Agency CMBS consists of bonds backed by commercial real estate which are guaranteed by FNMA. CLOs are floating rate securities that consist of pools of commercial loans structured to provide very strong over collateralization and subordination.  All of our CLOs are the senior AAA tranche and are the first bond to get paid down. Non-Agency CMOs are tracked individually with updates on the performance of the underlying collateral and stress testing performed. Both of our non-Agency CMOs held at March 31, 2013 were sold in early April 2013 for small gains. Additionally, we monitor individual bonds that experience greater levels prepayment or market volatility. 

We use an external pricing service to obtain fair market values for our investment portfolio.   We have obtained and reviewed the service provider’s pricing and reference data document. Evaluations are based on market data and vary by asset class and incorporate available trade, bid and other market information.  Because many fixed income securities do not trade on a daily basis, the service provider’s evaluated pricing applications apply available information as applicable through processes such as benchmark curves, benchmarking of like securities, sector groupings, and matrix pricing, to prepare evaluations.  In addition, model processes, such as the Option Adjusted Spread model are used to assess interest rate impact and develop prepayment scenarios.  We periodically test the values provided to us by the pricing service through a combination of back testing on actual sales of securities and by obtaining prices on all bonds from an alternative pricing source.

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

As a member of the Federal Home Loan Bank system, we are required to invest in stock of the FHLBB in an amount determined based on our borrowings from the FHLBB.  At March 31, 2013, our investment in FHLBB stock totaled $7.50 million.  Dividend income on FHLBB stock of $5 thousand and $17 thousand was recorded during the three months ended March 31, 2013 and 2012, respectively. The FHLBB continues to be classified as “adequately capitalized” by its primary regulator. Based on current available information, we have concluded that our investment in FHLBB stock is not impaired.  We will continue to monitor our investment in FHLBB stock. 

Deposits

Our deposit balances at March 31, 2013 decreased $1.30 million, or 0.1%, from a record high of $1.27 billion at December 31, 2012.  This decrease was primarily a result of large deposit inflows at the end of the year that were temporary in nature, and normal seasonal fluctuation in our municipal balances. Quarterly average deposits increased $5.76 million to $1.25 billion for the first quarter of 2013 from the fourth quarter of 2012. 

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CREDIT QUALITY AND ALLOWANCE FOR CREDIT LOSSES 

The United States economy continues to show slight improvement into 2013, although high unemployment and foreclosure rates continued in certain parts of the country.  Although Vermont, our primary market, has not been immune to this economic turmoil, the state has one of the lowest foreclosure rates in the country, home price depreciation has been muted, and the unemployment rate is lower than the national average.

Credit quality 

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

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

(In thousands)	March 31, 2013	December 31, 2012	March 31, 2012
Nonaccrual loans	$ 2,876	$ 2,355	$ 1,787
Loans past due 90 days or more and still accruing	0	0	0
Troubled debt restructurings (“TDR”)	539	557	528
Total nonperforming loans	3,415	2,912	2,315
OREO	0	0	350
Total nonperforming assets	$ 3,415	$ 2,912	$ 2,665

Non-performing loans at March 31, 2013 were $3.42 million.  The increase compared to December 31, 2012 was primarily due to the transfer to nonaccruing status of two commercial loans, the increase in a commercial line of credit balance, and the transfer to nonaccruing status of three residential mortgage customers. These increases were offset by the payoff of one nonperforming commercial loan and the upgrade of one residential mortgage loan to performing loan status.  Of the $3.42 million in nonperforming loans in the table above, $1.0 million are commercial  and commercial real estate loans, $9 thousand are consumer loans, and $2.4 million are residential mortgages and home equity loans.    

TDRs represent balances where the existing loan was modified involving a concession in rate, term or payment amount due to the distressed financial condition of the borrower. There were eight restructured residential mortgages at March 31, 2013 with balances totaling $360 thousand. There were two restructured commercial loans at March 31, 2013 with balances totaling $179 thousand.  Nine of the ten TDRs at March 31, 2013 continue to pay as agreed according to the modified terms and all but one of these loans are considered well-secured; one of the TDRs is in foreclosure. 

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

Year Ended	30-89 Days
March 31, 2013	0.09%
December 31, 2012	0.00%
March 31, 2012	0.01%
December 31, 2011	0.02%

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

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

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

A loan remains in nonaccruing status until the factors which suggest doubtful collectability no longer exist, the loan is liquidated, or

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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, we can, and may, initiate foreclosure proceedings.  The result of such action will either be to cause repayment of the loan with the proceeds of a foreclosure sale or to give us possession of the collateral in order to manage a future resale of the real estate.  Foreclosed property is recorded at the lower of its cost or estimated fair value, less any estimated costs to sell and is actively marketed.  Any cost in excess of the estimated fair value on the transfer date is charged to the allowance for loan losses, while further declines in market values are recorded as OREO expense in the consolidated statement of income. Impaired loans, which primarily consist of non-accruing loans and TDRs, totaled $3.42 million and $3.02 million at March 31, 2013 and December 31, 2012, respectively.  At March 31, 2013, $2.00 million of impaired loans had specific reserve allocations totaling $678 thousand. 

Substandard loans at March 31, 2013 totaled $26.86 million, of which $24.41 million in loans continue to accrue interest.  Loans identified as substandard have well-defined weaknesses that, if not addressed, could result in a loss.  These accruing substandard loans have generally continued to pay promptly and Management conducts regularly scheduled comprehensive reviews of the borrowers’ financial condition, payment performance, accrual status and collateral.  These reviews also ensure that these troubled accounts are properly administered with a focus on loss mitigation and that any potential loss exposures are appropriately quantified, and reserved for. The findings of this review process are a key component in assessing the adequacy of our loan loss reserve.

Accruing substandard loans at March 31, 2013 reflect a $7.05 million increase in balances since December 31, 2012. At March 31, 2013, accruing substandard loans related to owner-occupied commercial real estate totaled $15.75 million, investor commercial real estate loans totaled $1.40 million, residential mortgage loans totaled $806 thousand, multifamily real estate loans totaled $1.34 million, and $5.10 million in substandard loans are outstanding to corporate borrowers in a variety of different industries. Eight borrowers in a variety of industries account for 74% of the total accruing substandard loans, and approximately $2.10 million of the total accruing substandard loans carry some form of government guarantee.

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

Management monitors asset quality closely and continuously performs detailed and extensive reviews on larger credits and problematic credits identified on the watched asset list, nonperforming asset listings and internal credit rating reports.  In addition to frequent financial analysis and review of well-rated and adversely graded loans, Management incorporates active monitoring of key credit and non-credit risks for each customer, assessing risk through the daily reviews of overdrafts, delinquencies and usage of electronic banking products and tracking for timely receipt of all required financial statements.

Allowance for Credit Losses

The allowance for credit losses is made up of two components: the allowance for loan losses (“ALL”) and the reserve for undisbursed lines.  The ALL is based on Management's estimate of the amount required to reflect the known and inherent risks in the loan portfolio, based on circumstances and conditions known at each reporting date. We review the adequacy of the ALL quarterly. Factors considered in evaluating the adequacy of the ALL include previous loss experience, the size and composition of the portfolio, risk rating composition, current economic and real estate market conditions and their effect on the borrowers, the performance of individual loans in relation to contractual terms and estimated fair values of properties that secure impaired loans.

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

The general allowance for loan losses is a percentage-based reflection of historical loss experience and assigns a required allocation by loan classification based on a fixed percentage of all outstanding loan balances. The general allowance for loan losses employs a risk-rating model that grades loans based on their general characteristics of credit quality and relative risk. Appropriate reserve levels are estimated based on Management’s judgments regarding the historical loss experience, current economic trends, trends in the portfolio mix, volume and trends in delinquencies and non-accrual loans.

Losses are charged against the ALL when Management believes that the collectability of principal is doubtful. To the extent Management determines the level of anticipated losses in the portfolio increased or diminished, the ALL is adjusted through current earnings. Overall, Management believes that the ALL is maintained at an adequate level, in light of historical and current factors, to reflect the level of credit risk in the loan portfolio. Loan loss experience and nonperforming asset data are presented and discussed in relation to their impact on the adequacy of the ALL.

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The following table reflects our loan loss experience and activity in the Allowance for Credit Losses for the periods indicated:

(In thousands)	Three Months Ended March 31, 2013	Twelve Months Ended December 31, 2012	Three Months Ended March 31, 2012
Average loans outstanding	$ 1,086,289	$ 1,057,446	$ 1,034,277
Allowance beginning of year	12,312	11,353	11,353
Charge-offs:
Commercial, financial & agricultural	0	(9)	0
Real estate – residential	(7)	(20)	0
Real estate – commercial	(1)	(32)	0
Other	(20)	0	0
Total charge-offs	(28)	(61)	0
Recoveries:
Commercial, financial & agricultural	9	30	20
Real estate – residential	3	14	1
Real estate – commercial	40	1	1
Real estate – construction	1	25	7
Other	1	0	0
Total recoveries	54	70	29
Net  recoveries (charge-offs)	26	9	29
Provision for credit losses	250	950	250
Allowance end of year	$ 12,588	$ 12,312	$ 11,632
Components:
Allowance for loan losses	$ 11,796	$ 11,562	$ 11,049
Reserve for undisbursed lines of credit	792	750	583
Allowance for credit losses	$ 12,588	$ 12,312	$ 11,632

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

	March 31, 2013	December 31, 2012	March 31, 2012
NPL to total loans	0.31%	0.27%	0.22%
NPA to total assets	0.20%	0.17%	0.16%
Allowance for loan losses to total loans	1.07%	1.07%	1.06%
Allowance for loan losses to NPL	345%	397%	477%

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

Loan Portfolio Monitoring

Our Board of Directors grants each loan officer the authority to originate loans on our behalf, subject to certain limitations. The Board of Directors also establishes restrictions regarding the types of loans that may be granted and the distribution of loan types within our portfolio, and sets loan authority limits for each lender. These authorized lending limits are reviewed at least annually and are based upon the lender's knowledge and experience. Loan requests that exceed a lender's authority require the signature of our credit division manager, senior loan officer, and/or our President. All extensions of credit of $4.0 million or greater to any one borrower, or related party interest, are reviewed and approved by the Loan Committee of Merchants Bank’s Board of Directors.

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

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loan review firms to assist in monitoring both the commercial and residential loan portfolios. The commercial loan review firm reviews at a minimum 60% in dollar volume of our commercial loan portfolio each year. These comprehensive reviews assessed the accuracy of our risk rating system as well as the effectiveness of credit administration in managing overall credit risks.

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

Liquidity and Capital Resource Management

General

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

As of March 31, 2013, we could borrow up to $45 million in overnight funds through unsecured borrowing lines established with correspondent banks.  We have established both overnight and longer term lines of credit with FHLBB.  FHLBB borrowings are secured by residential mortgage loans. The total amount of loans pledged to the FHLBB for both short and long-term borrowing arrangements totaled $351.94 million at March 31, 2013. We have additional borrowing capacity with the FHLBB of $208.80 million as of March 31, 2013.  We have also established a borrowing facility with the Board of Governors of the Federal Reserve (“FRB”) which will enable us to borrow at the discount window. Additionally, we have the ability to borrow through the use of repurchase agreements, collateralized by Agency MBS and Agency CMO, with certain approved counterparties. Our investment portfolio, which is managed by the ALCO, has a cost basis of $501.03 million at March 31, 2013, of which $295.44 million was pledged.  The portfolio is a reliable source of cash flow for us. We closely monitor our short term cash position.  Any excess funds are either left on deposit at the FRB, or are in a fully insured account with one of our correspondent banks. 

The following table presents information regarding our short-term borrowings as of the dates indicated:

	Three Months Ended March 31, 2013	Year Ended December 31, 2012
FHLBB and other short-term borrowings
Amount outstanding at end of period	$ 30,900	$ 0
Maximum during the period amount outstanding	32,800	97,000
Average amount outstanding	13,873	38,290
Weighted average-rate during the period	0.28%	0.28%
Weighted average rate at period end	0.31%	0%
Securities sold under agreement to repurchase, short-term
Amount outstanding at end of period	$ 243,204	$ 287,520
Maximum during the period amount outstanding	287,520	303,420
Average amount outstanding	264,884	230,281
Weighted average-rate during the period	0.53%	0.73%
Weighted average rate at period end	0.60%	0.47%

Commitments and Off-Balance Sheet Risk

We are a party to financial instruments with off‑balance sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments primarily include commitments to extend credit and financial guarantees. Contingent obligations under standby letters of credit totaled approximately $4.71 million and $4.48 million at March 31, 2013 and December 31, 2012, respectively, and represent the maximum potential future payments we could be required to make. Typically, these instruments have terms of 12 months or less and expire unused; therefore, the total amounts do not necessarily represent future cash requirements. The fair value of our standby letters of credit at March 31, 2013 and 2012 was insignificant.

Capital Resources

We are subject to various regulatory capital requirements administered by federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have

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a direct material effect on our financial statements. Under capital adequacy guidelines, we must meet specific capital guidelines that involve quantitative measures of our assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. It is the policy of the FRB that banks and bank holding companies, respectively, should pay dividends only out of current earnings and only if, after paying such dividends, the bank or bank holding company would remain adequately capitalized. We are also subject to the regulatory framework for prompt corrective action that requires it to meet specific capital guidelines to be considered well capitalized. Our capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

Quantitative measures established by regulation to ensure capital adequacy require us to maintain minimum ratios (set forth in the table below) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined) and of Tier 1 capital (as defined) to average assets (as defined). Management believes, as of March 31, 2013, that Merchants met all capital adequacy requirements to which it is subject.

As of March 31, 2013, the most recent notification from the FDIC categorized Merchants Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that Management believes have changed Merchants Bank’s category. To be considered well capitalized under the regulatory framework for prompt corrective action, Merchants Bank must maintain minimum Tier 1 Leverage, Tier 1 Risk-Based, and Total Risk-Based Capital ratios. As of March 31, 2013 we exceeded all current applicable regulatory capital requirements. We continue to be considered well capitalized under current applicable regulations. Because we have no intangible assets, our tangible equity is the same as our book equity.

The following table represents our actual capital ratios and capital adequacy requirements as of March 31, 2013.

									To Be Well-
									Capitalized Under
					For Capital				Prompt Corrective
	Actual				Adequacy Purposes				Action Provisions
(In thousands)	Amount		Percent		Amount		Percent		Amount		Percent
Merchants Bancshares, Inc.:
Tier 1 Leverage Capital	$	138,115	8.22	%	$	67,245	4.00	%		N/A	N/A
Tier 1 Risk-Based Capital		138,115	14.86	%		37,189	4.00	%		N/A	N/A
Total Risk-Based Capital		149,748	16.11	%		74,377	8.00	%		N/A	N/A
Tangible Capital		119,154	7.04	%		N/A	N/A			N/A	N/A
Merchants Bank:
Tier 1 Leverage Capital	$	133,747	7.94	%	$	67,421	4.00	%	$	84,276	5.00	%
Tier 1 Risk-Based Capital		133,747	14.30	%		37,418	4.00	%		56,127	6.00	%
Total Risk-Based Capital		145,450	15.55	%		74,836	8.00	%		93,545	10.00	%
Tangible Capital		135,425	7.98	%		N/A	N/A			N/A	N/A

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

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ITEM 3 - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

General

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

Liquidity Risk

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

Market Risk – Interest Rate Risk

Market risk is the risk of loss in a financial instrument arising from adverse changes in market rates or prices such as interest rates, foreign currency exchange rates, commodity prices, and equity prices. Our primary market risk exposure is interest rate risk. An important component of our asset and liability management process is the ongoing monitoring and management of this risk, which is governed by established policies that are reviewed and approved annually by our Bank’s Board of Directors. Our investment policy details the types of securities that may be purchased, and establishes portfolio limits and maturity limits for the various sectors. Our investment policy also establishes specific investment quality limits. Our Bank’s Board of Directors has established a Board-level Asset and Liability Committee, which delegates responsibility for carrying out the asset/liability management policies to the Management-level Asset and Liability Committee (“ALCO”). The ALCO, chaired by the Chief Financial Officer and composed of members of senior management, develops guidelines and strategies impacting our asset and liability management-related activities based upon estimated market risk sensitivity, policy limits and overall market interest rate levels and trends. The ALCO manages the investment portfolio. Our goal is to maximize net interest income while mitigating market and interest rate risk.  We accomplish this through careful monitoring of the overall duration and average life of the portfolio, thorough analysis of securities we are considering for purchase, monitoring of individual securities, occasional repositioning of the investment portfolio, as well as selective sales of specific securities.

The ALCO is responsible for evaluating and managing the interest rate risk which arises naturally from imbalances in repricing, maturity and cash flow characteristics of our assets and liabilities. Techniques used by the ALCO take into consideration the cash flow and repricing attributes of balance sheet and off-balance sheet items and their relation to possible changes in interest rates. The ALCO manages interest rate exposure primarily by using on-balance sheet strategies, generally accomplished through the management of the duration, rate sensitivity and average lives of our various investments, and by extending or shortening maturities of borrowed funds, as well as carefully managing and monitoring the pricing of loans and deposits. The ALCO also considers the use of off-balance sheet strategies, such as interest rate caps and floors and interest rate swaps, to help minimize our exposure to changes in interest rates.  By using derivative financial instruments to hedge exposures to changes in interest rates we expose ourselves to credit risk and market risk.  Credit risk is the failure of the counterparty to perform under the terms of the derivative contract.  When the fair value of a derivative contract is positive, the counterparty owes us, which creates credit risk for us.  We minimize the credit risk in derivative instruments by entering into transactions only with high-quality counterparties.  The market risk associated with interest rate contracts is managed by establishing and monitoring parameters that limit the types and degree of market risk that may be undertaken.

The ALCO is responsible for ensuring that our Bank’s Board of Directors receives accurate information regarding our interest rate risk position at least quarterly. The ALCO uses an outside consultant to perform rate shocks of our balance sheet, and to perform a variety of other analyses. The ALCO consultant meets with the Board and Management-level ALCOs on a quarterly basis. During these meetings, the ALCO consultant reviews our current position and discusses future strategies, as well as reviewing the result of rate shocks of our balance sheet and a variety of other analyses. The consultant’s most recent review was as of March 31, 2013. The consultant ran a base simulation assuming no changes in rates as well as a 200 basis point rising and, because rates are quite low, a 100 basis point falling interest rate scenario which assumes a parallel and pro rata shift of the yield curve over a one-year period, and no growth assumptions.  Additionally, the consultant ran a 400 basis point rising simulation which assumed a parallel shift of the curve over 24 months, and a 500 basis point rising simulation which assumed the curve flattened over a 24 month time frame.   A summary of the results is as follows:

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

Falling Rates: If rates fall 100 basis points our net interest income is projected to trend in line with the base case over the first two quarters as we bring funding costs down to near zero.  Thereafter margins contract as asset yields continue to reprice lower while funding rates have reached their floors. 

Rising Rates:  Higher rates are better for us under all scenarios as our low cost deposits are worth more to us when they can be invested at higher rates. In the up 200 basis points scenario, net interest income is projected to move up quickly as asset yields reprice up more quickly than funding costs and asset cash flows are reinvested at higher rates. If rates remain at current low levels for another two years, the benefit of rising rates is muted because the starting point for asset yields will be lower. 

We have established a target range for the change in net interest income in year one of zero to 7.5%. The net interest income simulation as of March 31, 2013 showed that the change in net interest income for the next 12 months from our expected or “most likely” forecast was as follows:

Rate Change	Percent Change in Net Interest Income
Up 200 basis points	2.12	%
Down 100 basis points	(0.91)	%

The change in net interest income in the second year of the simulation shows a much more pronounced downward trend in the flat and down 100 basis points scenarios, the projected change is (5.84)% and (5.99)%, respectively, while the up 200 basis points simulation produces an increase of 8.25%.  The degree to which this exposure materializes will depend, in part, on our ability to manage our balance sheet as interest rates rise or fall.

The preceding sensitivity analysis does not represent our forecast and should not be relied upon as being indicative of expected operating results.  These estimates are based upon numerous assumptions including among others, the nature and timing of interest rate levels including yield curve shape, prepayments on loans and securities, deposit run-off rates, pricing decisions on loans and deposits and reinvestment/replacement of asset and liability cash flows. While assumptions are developed based upon current economic and local market conditions, we cannot make any assurances as to the predictive nature of these assumptions including how customer preferences or competitor influences might change.

The model used to perform the base case balance sheet simulation assumes a parallel shift of the yield curve over twelve months and reprices every interest earning asset and interest bearing liability on our balance sheet. Prepayment assumptions for all residential mortgage products take into account prepayment assumptions most recently published by Applied Financial Technologies. Prepayment assumptions for commercial loan and commercial mortgage products are derived through an analysis of historical prepayment patterns combined with analysis of the current characteristics of the portfolio. Investment securities with call provisions are examined on an individual basis in each rate environment to estimate the likelihood of a call. The model uses product-specific assumptions for deposits which are subject to repricing based on current market conditions

The most significant ongoing factor affecting market risk exposure of net interest income during the quarter ended March 31, 2013 was the sustained low interest rate environment.  Net interest income exposure is also significantly affected by the shape and level of the U.S. Government securities and interest rate swap yield curves, and changes in the size and composition of the loan, investment and deposit portfolios. 

As market conditions vary from those assumed in the sensitivity analysis, actual results will likely differ due to: the varying impact of changes in the balances and mix of loans and deposits differing from those assumed, the impact of possible off balance sheet hedging strategies, and other internal/external variables. Furthermore, the sensitivity analysis does not reflect all actions that the ALCO might take in responding to or anticipating changes in interest rates.

Credit Risk

The Board of Directors reviews and approves our loan policy on an annual basis. Among other things, the loan policy establishes restrictions regarding the types of loans that may be granted, and the distribution of loan types within our portfolio. Our Board of Directors grants each loan officer the authority to originate loans on our behalf, subject to certain limitations. These authorized lending limits are reviewed at least annually and are based upon the lender’s knowledge and experience. Loan requests that exceed a lender’s authority require the signature of our Credit Division Manager, Senior Loan Officer, and/or President. All extensions of credit of $4.0 million or greater to any one borrower or related party interest are reviewed and approved by the Loan Committee of our Board of Directors. Our loan portfolio is continuously monitored for performance, creditworthiness and strength of documentation through the use of a variety of management reports and the assistance of an external loan review firm.  Credit ratings are assigned to commercial loans and are routinely reviewed. Loan officers, under the supervision of the Senior Lender and Senior Credit Officer, take remedial actions to assure full and timely payment of loan balances when necessary.  Our policy is to discontinue the accrual of interest on

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loans when scheduled payments become contractually past due 90 or more days and the ultimate collectability of principal or interest become doubtful.  In certain instances the accrual of interest is discontinued prior to 90 days past due if Management determines that the borrower will not be able to continue making timely payments.

Item 4. Controls and Procedures

Our principal executive officer, principal financial officer, and other members of our senior management have evaluated our disclosure controls and procedures as of the end of the period covered by this quarterly report. Based on this evaluation, our principal executive officer and principal financial officer have concluded that the disclosure controls and procedures effectively ensure that information required to be disclosed in our filings and submissions with the SEC under the Securities Exchange Act of 1934, as amended, is accumulated and communicated to our management (including the principal executive officer and principal financial officer), and is recorded, processed, summarized and reported within the time periods specified by the SEC. In addition, we have reviewed our internal control over financial reporting and there have been no changes in our internal control over financial reporting during the quarter ended March 31, 2013 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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MERCHANTS BANCSHARES, INC.

PART II – OTHER INFORMATION

Item 1. Legal Proceedings

None.

Item 1A. Risk Factors

Please read the factors discussed in Part I – Item 1A, "Risk Factors" in our Annual Report on Form 10-K for the fiscal year ended December 31, 2012 filed with the SEC on March 6, 2013, which could materially adversely affect our business, financial condition and operating results. These risks are not the only ones facing us. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and operating results.

General economic and market conditions in the United States of America and abroad may materially and adversely affect the market price of shares of our common stock. Because of these and other factors, past financial performance should not be considered an indicator of future performance. The forward-looking statements contained herein represent our judgments as of the date of this Quarterly Report on Form 10-Q and we undertake no duty to update these forward-looking statements. We caution readers not to place undue reliance on such statements.

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

None.

Item 3. Defaults Upon Senior Securities

None.

Item 4. Mine Safety Disclosure

Not applicable.

Item 5. Other Information

None. 

Item 6. Exhibits

(a) Exhibits:

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

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

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

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

101**The following materials from Merchants Bancshares, Inc.’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2013 formatted in XBRL: (i) Consolidated Balance Sheets at March 31, 2013 and December 31, 2012; (ii) Consolidated Statements of Income for the three months ended March 31, 2013 and 2012; (iii) Consolidated Statements of Comprehensive Income for the three months ended March 31, 2013 and 2012; (iv) Consolidated Statements of Cash Flows for the three months ended March 31, 2013 and 2012; and (v) Notes to Interim Unaudited Consolidated Financial Statements.

_______________________________

*Filed herewith

**Furnished herewith

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MERCHANTS BANCSHARES, INC.

SIGNATURES

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

Merchants Bancshares, Inc.

/s/ Michael R. Tuttle

Michael R. Tuttle

President & Chief Executive Officer

/s/ Janet P. Spitler

Janet P. Spitler

Chief Financial Officer & Treasurer

Principal Accounting Officer

May 3, 2013

Date

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