Merchants Bancshares 10-Q 2014 Q3 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 September 30, 2014

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 October 27, 2014, there were 6,331,650 shares of the registrant’s common stock, par value $0.01 per share, outstanding.

MERCHANTS BANCSHARES, INC. AND SUBSIDIARIES

FORM 10-Q 

TABLE OF CONTENTS

PART I – FINANCIAL INFORMATION		Page Reference
Item 1	Financial Statements
	Consolidated Balance Sheets (Unaudited)
	As of September 30, 2014 and December 31, 2013	3
	Consolidated Statements of Income (Unaudited)
	Three and nine months ended September 30, 2014 and 2013	4
	Consolidated Statements of Comprehensive Income (Loss) (Unaudited)
	Three and nine months ended September 30, 2014 and 2013	5
	Consolidated Statements of Cash Flows (Unaudited)
	Nine months ended September  30, 2014 and 2013	6
	Notes to Interim Unaudited Consolidated Financial Statements	7
Item 2	Management's Discussion and Analysis of Financial Condition and Results of Operations	28
Item 3	Quantitative and Qualitative Disclosures about Market Risk	40
Item 4	Controls and Procedures	42
PART II - OTHER INFORMATION
Item 1	Legal Proceedings	43
Item 1A	Risk Factors	43
Item 2	Unregistered Sales of Equity Securities and Use of Proceeds	43
Item 3	Defaults Upon Senior Securities	43
Item 4	Mine Safety Disclosure	43
Item 5	Other Information	43
Item 6	Exhibits	43
	Signatures	44

2

ITEM 1 – FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Merchants Bancshares, Inc.

Consolidated Balance Sheets

(Unaudited)

	September 30		December 31,
(In thousands except share and per share data)	2014		2013
ASSETS
Cash and due from banks	$	27,283	$	30,434
Interest earning deposits with banks and other short-term investments		92,374		85,037
Total cash and cash equivalents		119,657		115,471
Investments:
Securities available for sale, at fair value		186,049		252,513
Securities held to maturity (fair value of $140,411 and $137,087)		142,110		140,826
Total investments		328,159		393,339
Loans		1,156,663		1,166,233
Less: Allowance for loan losses		12,019		12,042
Net loans		1,144,644		1,154,191
Federal Home Loan Bank stock		4,378		7,496
Bank premises and equipment, net		15,922		15,572
Investment in real estate limited partnerships		5,511		4,631
Bank owned life insurance		10,237		10,000
Other assets		19,078		24,769
Total assets	$	1,647,586	$	1,725,469
LIABILITIES
Deposits:
Demand (noninterest bearing)	$	544,425	$	266,299
Savings, interest bearing checking and money market accounts		525,680		752,171
Time deposits $100 thousand and greater		83,741		115,204
Other time deposits		150,235		189,902
Total deposits		1,304,081		1,323,576
Securities sold under agreements to repurchase		188,157		250,314
Other long-term debt		2,341		2,403
Junior subordinated debentures issued to unconsolidated subsidiary trust		20,619		20,619
Other liabilities		6,644		8,946
Total liabilities		1,521,842		1,605,858
Commitments and contingencies (Note 9)
SHAREHOLDERS' EQUITY
Preferred stock
Preferred stock		-		-
Class A non-voting shares authorized - 200,000,  none outstanding		-		-
Common stock, $.01 par value		67		67
Authorized: 10,000,000 shares; Issued: 6,651,760 at September 30, 2014 and December 31, 2013
Outstanding: 6,329,958 at September 30, 2014 and 6,318,708 at December 31, 2013
Capital in excess of par value		37,176		37,129
Retained earnings		99,967		95,657
Treasury stock, at cost: 321,802 shares at September 30, 2014 and 333,052 shares at December 31, 2013		(13,656)		(14,043)
Deferred compensation arrangements: 304,118 shares at September 30, 2014 and 319,854 shares at December 31, 2013		6,324		6,521
Accumulated other comprehensive loss		(4,134)		(5,720)
Total shareholders' equity		125,744		119,611
Total liabilities and shareholders' equity	$	1,647,586	$	1,725,469

See accompanying notes to unaudited consolidated financial statements

3

Merchants Bancshares, Inc.

Consolidated Statements of Income

(Unaudited)

	Three Months Ended				Nine Months Ended
	September				September
(In thousands except per share data)	2014		2013		2014		2013
INTEREST AND DIVIDEND INCOME
Interest and fees on loans	$	10,642	$	11,070	$	32,160	$	32,864
Investment income:
Interest and dividends on investment securities		1,885		2,301		6,145		7,649
Interest on interest earning deposits with banks and other short-term investments		37		13		110		38
Total interest and dividend income		12,564		13,384		38,415		40,551
INTEREST EXPENSE
Savings, interest bearing checking and money market accounts		370		416		1,283		758
Time deposits $100 thousand and greater		155		193		503		605
Other time deposits		278		339		855		1,059
Securities sold under agreement to repurchase and other short-term debt		62		83		241		817
Long-term debt		201		201		598		602
Total interest expense		1,066		1,232		3,480		3,841
Net interest income		11,498		12,152		34,935		36,710
Provision for credit losses		0		400		150		800
Net interest income after provision for credit losses		11,498		11,752		34,785		35,910
NONINTEREST INCOME
Trust division income		856		759		2,537		2,278
Net debit card income		678	��	720		2,014		2,114
Overdraft income		639		704		1,919		2,078
Service charges on deposits		331		291		977		894
Net gains (losses) on investment securities		(37)		1		106		(12)
Loss on sale of other assets		0		0		(35)		0
Other		409		311		1,217		846
Total noninterest income		2,876		2,786		8,735		8,198
NONINTEREST EXPENSE
Compensation and benefits		5,145		4,754		14,906		14,059
Occupancy expense		1,064		1,021		3,296		3,085
Equipment expense		978		889		2,916		2,768
Legal and professional fees		681		695		2,012		2,001
Marketing		521		393		1,163		1,158
State franchise  taxes		340		363		1,096		1,082
FDIC insurance		218		215		651		655
Conversion costs		442		0		830		0
Other		1,336		1,299		4,104		4,147
Total noninterest expense		10,725		9,629		30,974		28,955
Income before provision for income taxes		3,649		4,909		12,546		15,153
Provision for income taxes		843		1,235		2,923		3,845
NET INCOME	$	2,806	$	3,674	$	9,623	$	11,308
Basic earnings per common share	$	0.44	$	0.58	$	1.52	$	1.80
Diluted earnings per common share	$	0.44	$	0.58	$	1.52	$	1.79

See accompanying notes to unaudited consolidated financial statements

4

Merchants Bancshares, Inc.

Consolidated Statements of Comprehensive Income (Loss)

(Unaudited)

	Three Months Ended				Nine Months Ended
	September				September
(In thousands)	2014		2013		2014		2013
Net income	$	2,806	$	3,674	$	9,623	$	11,308
Other comprehensive income (loss),  net of tax:
Change in net unrealized gain (loss) on securities available for sale, net of taxes of $(317),  $1,453,  $594 and $(2,929)		(589)		2,698		1,102		(5,440)
Unrealized holding loss arising during the period for securities transferred from available for sale to held to maturity, net of taxes of $0,  $(1,701),  $4 and $(1,701)		0		(3,159)		8		(3,159)
Accretion of unrealized holding losses of securities transferred from available for sale to held to maturity, net of taxes of $68,  $70,  $189 and $70		127		129		351		129
Reclassification adjustments for net securities losses (gains) included in net income, net of taxes of $13,  $0,  $(37) and $4		24		0		(69)		8
Change in net unrealized loss on interest rate swaps, net of taxes of $36,  $3,  $71 and $93		66		6		131		172
Pension liability adjustment, net of taxes of $10,  $30,  $34 and $93		21		57		63		173
Other comprehensive income (loss)		(351)		(269)		1,586		(8,117)
Comprehensive income (loss)	$	2,455	$	3,405	$	11,209	$	3,191

See accompanying notes to unaudited consolidated financial statements

5

Merchants Bancshares, Inc.

Consolidated Statements of Cash Flows

(Unaudited)

	Nine Months Ended September 30,
(In thousands)	2014		2013
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	9,623	$	11,308
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses		150		800
Depreciation and amortization		1,944		1,526
Amortization of investment security premiums and accretion of discounts, net		477		974
Stock based compensation		136		141
Net (gain) loss on sales of investment securities		(106)		12
Accretion of deferred gain on sale of premises		(387)		(317)
Net gains on sale of premises, equipment and other assets		-		82
Loss on sale of other real estate owned		35		-
Equity in losses of real estate limited partnerships, net		981		811
Increase in cash surrender value of bank owned life insurance		(237)		-
Changes in assets and liabilities:
Net change in interest receivable		673		819
Net change in other assets		4,118		2,872
Net change in interest payable		(43)		(18)
Net change in other liabilities		(1,722)		161
Net cash provided by operating activities		15,642		19,171
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from sales of investment securities available for sale		56,889		53,215
Proceeds from maturities of investment securities available for sale		28,560		87,877
Proceeds from maturities of investment securities held to maturity		11,692		4,073
Proceeds from redemption of Federal Home Loan Bank stock		3,118		649
Purchases of investment securities available for sale		(30,190)		(55,774)
Loan originations less than (in excess of) principal payments		9,449		(85,240)
Proceeds from sales of loans, net		-		2,378
Proceeds from sale of premises and equipment		-		64
Proceeds from sales of other real estate owned		68		140
Real estate limited partnership investments		(1,823)		(102)
Purchases of bank premises and equipment		(2,293)		(2,052)
Net cash provided by investing activities		75,470		5,228
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase (decrease) in deposits		(19,495)		60,166
Net increase in short-term borrowings		-		8,200
Net decrease in securities sold under agreement to repurchase, short-term		(62,157)		(108,030)
Principal payments on long-term debt		(62)		(60)
Cash dividends paid		(5,312)		(4,827)
Sale of treasury stock		-		12
Increase in deferred compensation arrangements		176		186
Repurchased restricted stock to pay taxes on vested awards		(82)		-
Tax benefit from exercise of stock options		6		8
Net cash used in financing activities		(86,926)		(44,345)
Decrease in cash and cash equivalents		4,186		(19,946)
Cash and cash equivalents beginning of period		115,471		77,228
Cash and cash equivalents end of period	$	119,657	$	57,282
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Total interest payments	$	3,523	$	3,859
SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES
Distribution of stock under deferred compensation arrangements	$	553	$	450
Distribution of treasury stock in lieu of cash dividend under dividend reinvestment plan		-		460
Non-cash exercise of stock options		124		181
Transfer of loans to other real estate owned		-		163
Transfer of securities from available for sale to held to maturity		12,626		144,428

See accompanying notes to unaudited 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, 2013, filed with the Securities and Exchange Commission (the “SEC”) on March 10, 2014.

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 September 30, 2014 and December 31, 2013 and for the three and nine months ended September 30, 2014 and 2013 have been included. The information was prepared from our unaudited financial statements and the unaudited financial statements of our subsidiaries, Merchants Bank and MBVT Statutory Trust I.  Amounts reported for prior periods are reclassified, where necessary, to be consistent with the current period presentation.

Management’s Use of Estimates in Preparation of Financial Statements

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

NOTE 2: RECENT ACCOUNTING PRONOUNCEMENTS

In January 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-01, “Investments – Equity Method and Joint Ventures (Topic 323): Accounting for Investments in Qualified Affordable Housing Projects.” The amendments in this ASU modify the conditions that a reporting entity must meet to be eligible to use a method other than the equity or cost methods to account for qualified affordable housing project investments. If the modified conditions are met, the amendments permit an entity to amortize the initial cost of the investment in proportion to the amount of tax credits and other tax benefits received and recognize the net investment performance in the income statement as a component of income tax expense (benefit). Additionally, the amendments introduce new recurring disclosures about all investments in qualified affordable housing projects irrespective of the method used to account for the investments.  The amendments in this ASU are effective for public entities for annual periods and interim reporting periods within those annual periods, beginning after December 15, 2014.  In the first quarter of 2014, we early adopted this ASU for the reporting of our equity investments in qualified affordable housing projects.  The investments are recorded using the proportional amortization method whereby an entity amortizes the initial cost of the investment in proportion to the tax credits and other tax benefits received and recognizes the net investment performance in the income statement as a component of income tax expense (benefit).  The application of this standard reduced total noninterest expense by $327 thousand and $981 thousand for the three and nine months ended September 30, 2014, respectively; and by $271 thousand and $811 thousand for the three and nine months ended September 30, 2013, respectively.  The application of the standard also increased our effective tax rate to 23% from 16% for the three months and 17% for the nine months ended September 30, 2014, and to 25% from 21% for the three and nine months ended September 30, 2013, respectively.  This ASU was applied retrospectively and prior periods have been reclassified accordingly.

In May 2014, FASB issued ASU 2014-09, “Revenue from Contracts with Customers (Topic 606)”. The ASU provides guidance on revenue recognition for entities that enter into contracts with customers to transfer goods or services or enter into contracts for the transfer of nonfinancial assets. The principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. Additional disclosures are required to provide quantitative and qualitative information regarding the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. The new guidance is effective for annual reporting periods, and interim reporting periods within those annual periods, beginning after December 15, 2016. Early adoption is not permitted.  Management is currently evaluating the impact of the adoption of this guidance on our financial statements.

7

NOTE 3: INVESTMENT SECURITIES

Investments in securities are classified as available for sale or held to maturity as of September 30, 2014 and December 31, 2013. The amortized cost and fair values of the securities classified as available for sale and held to maturity as of September 30, 2014 are as follows:

				Gross		Gross
		Amortized		Unrealized		Unrealized		Fair
(In thousands)		Cost		Gains		Losses		Value
Available for Sale:
U.S. Treasury Obligations	$	20,057	$	-	$	40	$	20,017
Residential Real Estate Mortgage-backed Securities ("Agency MBSs")		87,162		2,584		479		89,267
Agency Commercial Mortgage Backed Securities ("Agency CMBSs")		17,988		-		528		17,460
Agency Collateralized Mortgage Obligations ("Agency CMOs")		59,118		190		391		58,917
Asset Backed Securities ("ABSs")		353		35		-		388
Total Available for Sale	$	184,678	$	2,809	$	1,438	$	186,049
				Gross		Gross
		Amortized		Unrecognized		Unrecognized		Fair
(In thousands)		Cost		Gains		Losses		Value
Held to Maturity:
U.S. Agency Obligations	$	22,259	$	147	$	27	$	22,379
U.S. Government Sponsored Enterprises ("U.S. GSEs")		9,483		-		148		9,335
Federal Home Loan Bank ("FHLB") Obligations		4,711		1		-		4,712
Agency MBSs		8,347		117		-		8,464
Agency CMOs		97,310		11		1,800		95,521
Total Held to Maturity	$	142,110	$	276	$	1,975	$	140,411

The amortized cost and fair values of the securities classified as available for sale and held to maturity as of December 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	$	-	$	-	$	100
Agency MBSs		97,882		2,876		1,487		99,271
Agency CMBSs		18,398		-		760		17,638
Agency CMOs		98,162		254		1,207		97,209
CLOs		37,834		73		-		37,907
ABSs		357		31		-		388
Total Available for Sale	$	252,733	$	3,234	$	3,454	$	252,513
				Gross		Gross
		Amortized		Unrecognized		Unrecognized		Fair
(In thousands)		Cost		Gains		Losses		Value
Held to Maturity:
U.S. Agency Obligations	$	23,580		-	$	458	$	23,122
U.S. GSEs		9,442		-		512		8,930
FHLB Obligations		4,684		-		191		4,493
Agency CMOs		94,105		-		2,426		91,679
Agency MBSs		9,015		25		177		8,863
Total Held to Maturity	$	140,826	$	25	$	3,764	$	137,087

8

The contractual final maturity distribution of the debt securities classified as available for sale as of September 30, 2014, 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	$	-	$	20,017	$	-	$	-	$	20,017
Agency MBSs		61		3,077		17,472		68,657		89,267
Agency CMBSs		-		4,883		8,359		4,218		17,460
Agency CMOs		-		-		2,481		56,436		58,917
ABSs		-		-		-		388		388
Total Available for Sale	$	61	$	27,977	$	28,312	$	129,699	$	186,049
Available for Sale (at amortized cost):
U.S. Treasury Obligations	$	-	$	20,057	$	-	$	-	$	20,057
Agency MBSs		58		2,911		16,693		67,500		87,162
Agency CMBSs		-		4,964		8,618		4,406		17,988
Agency CMOs		-		-		2,469		56,649		59,118
ABSs		-		-		-		353		353
Total Available for Sale	$	58	$	27,932	$	27,780	$	128,908	$	184,678

The contractual final maturity distribution of the debt securities classified as held to maturity as of September 30, 2014, are as follows:

				After One		After Five
		Within		But Within		But Within		After Ten
(In thousands)		One Year		Five Years		Ten Years		Years		Total
Held to Maturity (at fair value):
U.S. Agency Obligations	$	-	$	-	$	-	$	22,379	$	22,379
U.S. GSEs		-		-		9,335		-		9,335
FHLB Obligations		-		-		4,712		-		4,712
Agency MBSs		-		16		115		8,333		8,464
Agency CMOs		-		-		-		95,521		95,521
Total Held to Maturity	$	-	$	16	$	14,162	$	126,233	$	140,411
Held to Maturity (at amortized cost):
U.S. Agency Obligations	$	-	$	-	$	-	$	22,259	$	22,259
U.S. GSEs		-		-		9,483		-		9,483
FHLB Obligations		-		-		4,711		-		4,711
Agency MBSs		-		16		101		8,230		8,347
Agency CMOs		-		-		-		97,310		97,310
Total Held to Maturity	$	-	$	16	$	14,295	$	127,799	$	142,110

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 tables 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 and nine months ended September 30, 2014 and 2013.

	Three Months Ended September 30,				Nine Months Ended September 30,
(In thousands)		2014		2013		2014		2013
Proceeds	$	11,674	$	2,001	$	56,889	$	53,215
Gross gains		-		1		302		548
Gross losses		(37)		-		(196)		(560)
Net gains	$	(37)	$	1	$	106	$	(12)

Securities with a carrying amount of $254.67 million and $315.53 million at September 30, 2014 and December 31, 2013, 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 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 September 30, 2014, were as follows:

		Less Than 12 Months				12 Months or More				Total
		Fair				Fair				Fair
(In thousands)		Value		Loss		Value		Loss		Value		Loss
Available for Sale:
U.S. Treasury Obligations	$	20,017	$	40	$	-	$	-	$	20,017	$	40
Agency MBSs		9,532		48		27,847		431		37,379		479
Agency CMBSs		-		-		17,460		528		17,460		528
Agency CMOs		20,912		98		11,374		293		32,286		391
Total Available for Sale	$	50,461	$	186	$	56,681	$	1,252	$	107,142	$	1,438
Held to Maturity:
U.S. Agency Obligations	$	8,817	$	27	$	-	$	-	$	8,817	$	27
U.S. GSEs		-		-		9,335		148		9,335		148
Agency CMOs		50,726		834		36,534		966		87,260		1,800
Total Held to Maturity	$	59,543	$	861	$	45,869	$	1,114	$	105,412	$	1,975

Gross unrealized losses on investment securities and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in continuous unrealized loss position over our entire holding period, at December 31, 2013, were as follows:

		Less Than 12 Months				12 Months or More				Total
		Fair				Fair				Fair
(In thousands)		Value		Loss		Value		Loss		Value		Loss
Available for Sale:
Agency MBSs	$	46,547	$	1,487	$	-	$	-	$	46,547	$	1,487
Agency CMBSs		12,778		578		4,860		182		17,638		760
Agency CMOs		57,904		977		3,557		230		61,461		1,207
Total Available for Sale	$	117,229	$	3,042	$	8,417	$	412	$	125,646	$	3,454
Held to Maturity:
U.S. Agency Obligations	$	13,722	$	307	$	9,400	$	151	$	23,122	$	458
U.S. GSEs		8,930		512		-		-		8,930		512
FHLB Obligations		4,493		191		-		-		4,493		191
Agency CMOs		66,203		1,410		25,476		1,016		91,679		2,426
Agency MBSs		8,569		177		-		-		8,569		177
Total Held to Maturity	$	101,917	$	2,597	$	34,876	$	1,167	$	136,793	$	3,764

There were no securities classified as trading at September 30, 2014 and December 31, 2013.

10

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.

At September 30, 2014, all of our Agency MBSs and Agency CMOs held were issued by U.S. government-sponsored entities and agencies, primarily the Federal National Mortgage Association (“FNMA”) and Federal Home Loan Mortgage Corp (“FHLMC”), institutions which the government has affirmed its commitment to support.  Because the decline in fair value is attributable to changes in interest rates, and not credit quality, and because we do not have the intent to sell these securities and it is not likely that we will be required to sell the securities before their anticipated recovery, we do not consider these securities to be other-than-temporarily impaired at September 30, 2014.

During the second and third quarters of 2014, we sold all of our CLOs.  We sold a total of $35.75 million for a small loss during the nine months ended September 30, 2014.  Under the Volker Rule, we may have been required to divest our CLOs by July 2017.

We use external pricing services to obtain fair market values for our investment portfolio.   We have obtained and reviewed the service providers’ pricing and reference data documentation. 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, with inputs determined based on knowledge of the market.  We periodically test the values provided to us by the pricing service 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.  During 2013 and the first quarter of 2014, we transferred securities from available for sale to held to maturity.  The unrealized holding loss at the time of transfer continues to be reported in accumulated other comprehensive income, net of tax and is amortized over the remaining lives of the securities as an adjustment of the yield.  The amortization of the unamortized holding loss reported in accumulated other comprehensive income will offset the effect on interest income of the discount for the transferred securities.  The remaining unamortized balance of the losses for the securities transferred from available for sale to held to maturity during 2013 and 2014 was $4.52 million, or $2.94 million, net of tax, at September 30, 2014.  

NOTE 4: LOANS AND THE ALLOWANCE FOR CREDIT LOSSES

The composition of our loan portfolio at September 30, 2014 and December 31, 2013 was as follows:

(In thousands)		September 30, 2014		December 31, 2013
Commercial, financial and agricultural	$	183,069	$	172,810
Municipal loans		96,258		94,007
Real estate loans – residential		472,986		489,706
Real estate loans – commercial		381,301		371,319
Real estate loans – construction		17,970		31,841
Installment loans		4,793		5,655
All other loans		286		895
Total loans	$	1,156,663	$	1,166,233

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 $646 thousand and $618 thousand of net deferred loan origination costs at September 30, 2014 and December 31, 2013, respectively. The aggregate amount of overdrawn deposit balances classified as loan balances was $286 thousand and $895 thousand at September 30, 2014 and December 31, 2013, respectively.

11

The following table reflects our loan loss experience and activity in the allowance for credit losses by portfolio segment for the three months ended September 30, 2014:

	Commercial,
	financial and				Real estate-		Real estate-		Real estate-
(In thousands)	agricultural		Municipal		residential		commercial		construction		Installment		All Other		Total
Allowance for credit losses:
Beginning balance	$	3,656	$	386	$	3,246	$	5,089	$	494	$	18	$	17	$	12,906
Charge-offs		-		-		(7)		-		-		-		(48)		(55)
Recoveries		-		-		-		-		-		-		7		7
Provision (credit)		(253)		316		42		(45)		(94)		(2)		36		-
Ending balance	$	3,403	$	702	$	3,281	$	5,044	$	400	$	16	$	12	$	12,858

The following table reflects our loan loss experience and activity in the allowance for credit losses by portfolio segment for the nine months ended September 30, 2014:

	Commercial,
	financial and				Real estate-		Real estate-		Real estate-
(In thousands)	agricultural		Municipal		residential		commercial		construction		Installment		All Other		Total
Allowance for credit losses:
Beginning balance		3,354		768		3,081		5,085		512		18		10	$	12,828
Charge-offs		(34)		-		(25)		-		-		-		(99)		(158)
Recoveries		3		-		20		-		-		1		14		38
Provision (credit)		80		(66)		205		(41)		(112)		(3)		87		150
Ending balance	$	3,403	$	702	$	3,281	$	5,044	$	400	$	16	$	12	$	12,858

The following table reflects our loan loss experience and activity in the allowance for credit losses by portfolio segment for the three months ended September 30, 2013:

	Commercial,
	financial and				Real estate-		Real estate-		Real estate-
(In thousands)	agricultural		Municipal		residential		commercial		construction		Installment		All Other		Total
Allowance for credit losses:
Beginning balance	$	3,274	$	400	$	3,385	$	5,018	$	551	$	21	$	9	$	12,658
Charge-offs		-		-		(49)		-		-		(9)		(27)		(85)
Recoveries		13		-		-		-		1		-		4		18
Provision (credit)		137		346		(192)		100		(19)		6		22		400
Ending balance	$	3,424	$	746	$	3,144	$	5,118	$	533	$	18	$	8	$	12,991

12

The following table reflects our loan loss experience and activity in the allowance for credit losses by portfolio segment for the nine months ended September 30, 2013:

	Commercial,
	financial and				Real estate-		Real estate-		Real estate-
(In thousands)	agricultural		Municipal		residential		commercial		construction		Installment		All Other		Total
Allowance for credit losses:
Beginning balance	$	3,447		522		3,421		4,660		234		17		11	$	12,312
Charge-offs		-		-		(152)		(1)		-		(9)		(75)		(237)
Recoveries		62		-		4		40		2		-		8		116
Provision (credit)		(85)		224		(129)		419		297		10		64		800
Ending balance	$	3,424	$	746	$	3,144	$	5,118	$	533	$	18	$	8	$	12,991

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 September 30, 2014:

	Commercial,
	financial and				Real estate-		Real estate-		Real estate-				All
(In thousands)	agricultural		Municipal		residential		commercial		construction		Installment		Other		Total
Allowance for credit losses:
Ending balance individually evaluated for impairment	$	-	$	-	$	34	$	66	$	-	$	-	$	-	$	100
Ending balance collectively evaluated for impairment		3,403		702		3,247		4,978		400		16		12		12,758
Totals	$	3,403	$	702	$	3,281	$	5,044	$	400	$	16	$	12	$	12,858
Financing receivables:
Ending balance individually evaluated for impairment	$	64	$	-	$	514	$	154	$	-	$	-	$	-	$	732
Ending balance collectively evaluated for impairment		183,005		96,258		472,472		381,147		17,970		4,793		286		1,155,931
Totals	$	183,069	$	96,258	$	472,986	$	381,301	$	17,970	$	4,793	$	286	$	1,156,663
Components:
Allowance for loan losses	$	2,798	$	688	$	3,195	$	5,005	$	305	$	16	$	12	$	12,019
Reserve for undisbursed lines of credit		605		14		86		39		95		-		-		839
Total allowance for credit losses	$	3,403	$	702	$	3,281	$	5,044	$	400	$	16	$	12	$	12,858

13

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, 2013:

	Commercial,
	financial and				Real estate-		Real estate-		Real estate-				All
(In thousands)	agricultural		Municipal		residential		commercial		construction		Installment		Other		Total
Allowance for credit losses:
Ending balance individually evaluated for impairment	$	2	$	-	$	41	$	69	$	-	$	-	$	-	$	112
Ending balance collectively evaluated for impairment		3,352		768		3,040		5,016		512		18		10		12,716
Totals	$	3,354	$	768	$	3,081	$	5,085	$	512	$	18	$	10	$	12,828
Financing receivables:
Ending balance individually evaluated for impairment	$	20	$	-	$	722	$	164	$	-	$	-	$	-	$	906
Ending balance collectively evaluated for impairment		172,790		94,007		488,984		371,155		31,841		5,655		895		1,165,327
Totals	$	172,810	$	94,007	$	489,706	$	371,319	$	31,841	$	5,655	$	895	$	1,166,233
Components:
Allowance for loan losses	$	2,740	$	758	$	2,995	$	5,040		481	$	18	$	10	$	12,042
Reserve for undisbursed lines of credit		614		10		86		45		31		-		-		786
Total allowance for credit losses	$	3,354	$	768	$	3,081	$	5,085	$	512	$	18	$	10	$	12,828

The table below presents the recorded investment of loans, including nonaccrual and restructured loans, segregated by class, with delinquency aging as of September 30, 2014:

													Greater
	30-59		60-89		90 Days								Than 90
	Days		Days		or More		Total Past						Days and
(In thousands)	Past Due		Past Due		Past Due		Due		Current		Total		Accruing
Commercial, financial and agricultural	$	43	$	95	$	-	$	138	$	182,931	$	183,069	$	-
Municipal		-		-		-		-		96,258		96,258		-
Real estate-residential:
First mortgage		-		9		176		185		434,722		434,907		-
Second mortgage		28		-		79		107		37,972		38,079		-
Real estate-commercial:
Owner occupied		-		-		-		-		241,480		241,480		-
Non-owner occupied		-		-		-		-		139,821		139,821		-
Real estate-construction:
Residential		-		-		-		-		3,374		3,374		-
Commercial		-		-		-		-		14,596		14,596		-
Installment		-		-		-		-		4,793		4,793		-
All other loans		-		-		-		-		286		286		-
Total	$	71	$	104	$	255	$	430	$	1,156,233	$	1,156,663	$	-

Of the total past due loans in the aging table above, $255 thousand are non-performing, none of which are restructured or greater than 90 days past due and accruing.  There were $175 thousand past due performing loans at September 30, 2014.

14

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

													Greater
	30-59		60-89		90 Days								Than 90
	Days		Days		or More		Total Past						Days and
(In thousands)	Past Due		Past Due		Past Due		Due		Current		Total		Accruing
Commercial, financial and agricultural	$	-	$	-	$	20	$	20	$	172,790	$	172,810	$	-
Municipal		-		-		-		-		94,007		94,007		-
Real estate-residential:
First mortgage		4		294		341		639		452,440		453,079		-
Second mortgage		-		4		181		185		36,442		36,627		75
Real estate-commercial:
Owner occupied		-		-		-		-		224,416		224,416		-
Non-owner occupied		72		-		-		72		146,831		146,903		-
Real estate-construction:
Residential		-		-		-		-		2,495		2,495		-
Commercial		-		-		-		-		29,346		29,346		-
Installment		-		-		-		-		5,655		5,655		-
All other loans		-		-		-		-		895		895		-
Total	$	76	$	298	$	542	$	916	$	1,165,317	$	1,166,233	$	75

Of the total past due loans in the aging table above, $542 thousand are non-performing, of which $42 thousand are restructured loans and $75 thousand are greater than 90 days past due and accruing.  There were $374 thousand past due performing loans at December 31, 2013.

Impaired loans by class at September 30, 2014 and for the three and nine months ended September 30, 2014 are as follows:

							Three Months Ended				Nine Months Ended
							September 30, 2014				September 30, 2014
			Unpaid				Average		Interest		Average		Interest
	Recorded		Principal		Related		Recorded		Income		Recorded		Income
(In thousands)	Investment		Balance		Allowance		Investment		Recognized		Investment		Recognized
With no related allowance recorded
Commercial, financial and agricultural	$	64	$	65	$	-	$	66	$	1	$	65	$	2
Real estate – residential:
First mortgage		280		418		-		283		1		284		7
Second mortgage		78		78		-		131		-		156		1
Real estate – commercial:
Owner occupied		-		-		-		-		-		17		1
With related allowance recorded
Commercial, financial and agricultural		-		-		-		-		-		16		-
Real estate – residential:
First mortgage		155		155		34		190		-		189		-
Real estate – commercial:
Owner occupied		155		173		66		156		-		159		-
Total
Commercial, financial and agricultural		64		65		-		66		1		81		2
Real estate – residential		513		651		34		604		1		629		8
Real estate – commercial		155		173		66		156		-		176		1
Total	$	732	$	889	$	100	$	826	$	2	$	886	$	11

15

Impaired loans by class at December 31, 2013 and for the three and nine months ended September 30, 2013 are as follows:

							Three Months Ended				Nine Months Ended
							September 30, 2013				September 30, 2013
			Unpaid				Average		Interest		Average		Interest
	Recorded		Principal		Related		Recorded		Income		Recorded		Income
(In thousands)	Investment		Balance		Allowance		Investment		Recognized		Investment		Recognized
With no related allowance recorded
Commercial, financial and agricultural	$	-	$	-	$	-	$	272	$	15	$	223	$	42
Real estate – residential:
First mortgage		410		629		-		463		24		622		68
Second mortgage		181		218		-		188		1		133		2
Real estate – commercial:
Owner occupied		-		-		-		107		-		83		15
Installment		-		-		-		-		-		1		-
With related allowance recorded
Commercial, financial and agricultural		20		21		2		333		-		342		-
Real estate – residential:
First mortgage		131		135		41		399		-		523		-
Second mortgage		-		-		-		18		-		317		-
Real estate – commercial:
Owner occupied		164		175		69		168		-		171		-
Installment		-		-		-		6		-		6		-
Total
Commercial, financial and agricultural		20		21		2		605		15		565		42
Real estate – residential		722		982		41		1,068		25		1,595		70
Real estate – commercial		164		175		69		275		-		254		15
Installment		-		-		-		6		-		7		-
Total	$	906	$	1,178	$	112	$	1,954	$	40	$	2,421	$	127

Residential and commercial loans serviced for others at September 30, 2014 and December 31, 2013 amounted to approximately $13.33 million and $13.83 million, respectively. 

Nonperforming loans at September 30, 2014 and December 31, 2013 are as follows:

(In thousands)		September 30, 2014		December 31, 2013
Nonaccrual  loans	$	308	$	425
Loans greater than 90 days and accruing		-		75
Troubled debt restructurings ("TDRs")		424		406
Total nonperforming loans	$	732	$	906

Of the total TDRs in the table above, $222 thousand at September 30, 2014 and $235 thousand at December 31, 2013, are nonaccruing. We have reviewed all restructurings that occurred on or after January 1, 2014 for identification as TDRs. There were four TDRs that were restructured during 2014. We did not identify as a TDR any loan for which the allowance for credit losses had been measured under a general allowance for credit losses methodology.

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. All TDRs at September 30, 2014 continue to pay as agreed according to the modified terms and all but one of these loans are considered well-secured.  At September 30, 2014, there were no commitments to lend additional funds to borrowers whose loans have been modified in a TDR. We had no 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 at September 30, 2014. Interest income on restructured loans during the three and nine months ended September 30, 2014 and 2013 was insignificant.

16

Nonaccrual loans by class as of September 30, 2014 and December 31, 2013 are as follows:

(In thousands)		September 30, 2014		December 31, 2013
Commercial, financial and agricultural	$	11	$	20
Real estate - residential:
First mortgage		218		299
Second mortgage		79		106
Total nonaccruing non-TDR loans		308		425
Nonaccruing TDR’s
Commercial, financial and agricultural		5		-
Real estate – residential:
First mortgage		62		71
Real estate - commercial:
Owner occupied		155		164
Total nonaccrual loans including TDRs	$	530	$	660

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

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

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

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.

17

Below is a summary of loans by credit quality indicator as of September 30, 2014:

						Pass-		Special		Sub-
(In thousands)		Unrated		Pass		Watch		Mention		Standard		Total
Commercial, financial and agricultural	$	247	$	153,403	$	10,772	$	13,043	$	5,604	$	183,069
Municipal		55		73,502		20,804		1,897		-		96,258
Real estate – residential:
First mortgage		431,494		3,004		172		-		237		434,907
Second mortgage		38,079		-		-		-		-		38,079
Real estate – commercial:
Owner occupied		166		200,491		20,668		4,308		15,847		241,480
Non-owner occupied		130		119,757		18,095		258		1,581		139,821
Real estate – construction:
Residential		149		2,022		1,203		-		-		3,374
Commercial		190		11,999		444		-		1,963		14,596
Installment		4,756		37		-		-		-		4,793
All other loans		286		-		-		-		-		286
Total	$	475,552	$	564,215	$	72,158	$	19,506	$	25,232	$	1,156,663

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

						Pass-		Special		Sub-
(In thousands)		Unrated		Pass		Watch		Mention		Standard		Total
Commercial, financial and agricultural	$	242	$	152,466	$	14,092	$	96	$	5,914	$	172,810
Municipal		28		65,474		26,548		1,957		-		94,007
Real estate – residential:
First mortgage		449,951		2,520		-		65		543		453,079
Second mortgage		36,599		-		-		-		28		36,627
Real estate – commercial:
Owner occupied		165		187,779		17,236		2,342		16,894		224,416
Non-owner occupied		171		134,222		9,841		270		2,399		146,903
Real estate – construction:
Residential		904		1,591		-		-		-		2,495
Commercial		738		28,127		481		-		-		29,346
Installment		5,655		-		-		-		-		5,655
All other loans		895		-		-		-		-		895
Total	$	495,348	$	572,179	$	68,198	$	4,730	$	25,778	$	1,166,233

The amount of interest which was not earned, but which would have been earned had our nonaccrual and restructured loans performed in accordance with their original terms and conditions, was approximately $11 thousand and $32 thousand for the three months ended September 30, 2014 and 2013, respectively; and $29 thousand and $108 thousand for the nine months ended September 30, 2014 and 2013, respectively.

It is our policy to make loans to directors, executive officers, and associates of such persons on substantially the same terms, including interest rates and collateral, as those prevailing for comparable lending transactions with other persons.

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NOTE 5: 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.

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

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

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

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Financial instruments on a recurring basis

The table below presents the balance of financial assets and liabilities at September 30, 2014 measured at fair value on a recurring basis:

				Fair Value Measurements at Reporting Date Using
				Quoted Prices in		Significant
				Active Markets		Other		Significant
				for Identical		Observable		Unobservable
				Assets		Inputs		Inputs
(In thousands)		Total		(Level 1)		(Level 2)		(Level 3)
Assets
U.S. Treasury Obligations	$	20,017	$	-	$	20,017	$	-
Agency MBSs		89,267		-		89,267		-
Agency CMBSs		17,460		-		17,460		- ��
Agency CMOs		58,917		-		58,917		-
ABSs		388		-		388		-
Interest rate swap agreements		381		-		381		-
Total assets	$	186,430	$	-	$	186,430	$	-
Liabilities
Interest rate swap agreements		906		-		906		-
Total liabilities	$	906	$	-	$	906	$	-

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

				Fair Value Measurements at Reporting Date Using
				Quoted Prices in		Significant
				Active Markets		Other		Significant
				for Identical		Observable		Unobservable
				Assets		Inputs		Inputs
(In thousands)		Total		(Level 1)		(Level 2)		(Level 3)
Assets
U.S. Treasury Obligations	$	100	$	-	$	100	$	-
Agency MBSs		99,271		-		99,271		-
Agency CMBSs		17,638		-		17,638		-
Agency CMOs		97,209		-		97,209		-
CLOs		37,907		-		37,907		-
ABSs		388		-		388		-
Interest rate swap agreements		803		-		803		-
Total assets	$	253,316	$	-	$	253,316	$	-
Liabilities
Interest rate swap agreements		1,529		-		1,529		-
Total liabilities	$	1,529	$	-	$	1,529	$	-

Investment securities are reported at fair value utilizing Level 2 inputs. The prices for these instruments are obtained through an independent pricing service or dealer market participant with whom we have historically transacted both purchases and sales of investment securities. Prices obtained from these sources include market quotations and matrix pricing. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things.  More information regarding our investment securities can be found in Note 3 to these consolidated financial statements.

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

There were no transfers between Level 1 and Level 2 for the three and nine months ended September 30, 2014.  There were no Level 3 assets measured at fair value on a recurring basis during the three and nine months ended September 30, 2014.

Financial instruments on a non-recurring basis

Certain financial assets are also measured at fair value on a non-recurring basis; however, they were not material at September 30, 2014 or December 31, 2013. These financial assets include impaired loans and OREO.

The table below presents the balance of financial instruments by class at September 30, 2014 measured at fair value:

		Carrying
(In thousands)		Amount		Fair Value		Level 1		Level 2		Level 3
Cash and cash equivalents	$	119,657	$	119,657	$	119,657	$	-	$	-
Securities available for sale		186,049		186,049		-		186,049		-
Securities held to maturity		142,110		140,411		-		140,411		-
FHLB stock		4,378		N/A		N/A		N/A		N/A
Loans, net of allowance for loan losses		1,144,644		1,143,582		-		-		1,143,582
Interest rate contract-cash flow hedge		381		381		-		381		-
Accrued interest receivable		3,309		3,309		-		806		2,503
Total assets	$	1,600,528	$	1,593,389	$	119,657	$	327,647	$	1,146,085
Deposits	$	1,304,081	$	1,304,361	$	1,070,105	$	234,256	$	-
Securities sold under agreement to repurchase		188,157		188,140		-		188,140		-
Other long-term debt		2,341		2,275		-		2,275		-
Junior subordinated debentures issued to unconsolidated subsidiary trust		20,619		14,259		-		14,259		-
Interest rate contract-cash flow hedge		906		906		-		906		-
Accrued interest payable		171		171		15		156		-
Total liabilities	$	1,516,275	$	1,510,112	$	1,070,120	$	439,992	$	-

The table below presents the balance of financial instruments by class at December 31, 2013 measured at fair value:

		Carrying
(In thousands)		Amount		Fair Value		Level 1		Level 2		Level 3
Cash and cash equivalents	$	115,471	$	115,471	$	115,471	$	-	$	-
Securities available for sale		252,513		252,513		-		252,513		-
Securities held to maturity		140,826		137,087		-		137,087		-
FHLB stock		7,496		N/A		N/A		N/A		N/A
Loans, net of allowance for loan losses		1,154,191		1,155,348		-		-		1,155,348
Interest rate swap agreement		803		803		-		803		-
Accrued interest receivable		3,982		3,982		-		958		3,024
Total assets	$	1,675,282	$	1,665,204	$	115,471	$	391,361	$	1,158,372
Deposits	$	1,323,576	$	1,324,634	$	1,018,470	$	306,162	$	-
Securities sold under agreement to repurchase		250,314		250,290		-		250,290		-
Other long-term debt		2,403		2,287		-		2,287		-
Junior subordinated debentures issued to unconsolidated subsidiary trust		20,619		14,189		-		14,189		-
Interest rate swap agreement		1,529		1,529		-		1,529		-
Accrued interest payable		214		214		15		199		-
Total liabilities	$	1,598,655	$	1,593,143	$	1,018,485	$	574,656	$	-

The carrying amounts reported in the consolidated balance sheets for cash and cash equivalents, accrued interest receivable and

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accrued interest payable approximate fair value. It is not practical to determine the fair value of FHLB stock due to restrictions placed on its transferability.

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

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

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

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

Commitments to Extend Credit and Standby Letters of Credit - The fair value of commitments to extend credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of financial standby letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties. The fair value of commitments to extend credit and standby letters of credit is approximately $76 thousand at September 30, 2014 and $47 thousand as of December 31, 2013, 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 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.

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NOTE 6: EMPLOYEE BENEFIT PLANS

Pension Plan

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

The following tables summarize the components of net periodic benefit cost and other changes in Pension Plan assets and benefit obligations recognized for the three and nine months ended September 30, 2014 and 2013:

		Three Months				Nine Months
		Ended September				Ended September
(In thousands)		2014		2013		2014		2013
Interest cost	$	116	$	105	$	348	$	314
Expected return on plan assets		(265)		(247)		(795)		(741)
Service costs		11		10		33		40
Net loss amortization		31		87		97		266
Net periodic pension cost	$	(107)	$	(45)	$	(317)	$	(121)

We have no minimum required contribution for 2014.

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

NOTE 7: EARNINGS PER SHARE

The following table presents reconciliations of the calculations of basic and diluted earnings per share for the three and nine months ended September 30, 2014 and 2013:

	Three Months				Nine Months
		Ended September 30,				Ended September 30,
(In thousands except per share data)	2014		2013		2014		2013
Net income	$	2,806	$	3,674	$	9,623	$	11,308
Weighted average common shares outstanding		6,329		6,309		6,325		6,298
Dilutive effect of common stock equivalents		16		15		19		13
Weighted average common and common equivalent
shares outstanding		6,345		6,324		6,344		6,311
Basic earnings per common share	$	0.44	$	0.58	$	1.52	$	1.80
Diluted earnings per common share	$	0.44	$	0.58	$	1.52	$	1.79

Basic earnings per common share were computed by dividing net income by the weighted average number of shares of common stock outstanding for the three and nine months ended September 30, 2014 and 2013. 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 and nine months ended September 30, 2014 or 2013.

NOTE 8: STOCK REPURCHASE PROGRAM

We extended our stock buyback program through January 2015. Under the program, which was originally adopted in January 2007, we may repurchase up to 200,000 shares of our common stock on the open market from time to time, and have purchased 143,475 shares at an average price per share of $22.94 since the program’s adoption. We did not repurchase any of our shares during 2013 or during the first nine months of 2014, and do not expect to repurchase shares in the near future. 

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NOTE 9: 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 our 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 $7.58 million and $4.73 million at September 30, 2014 and December 31, 2013, 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 September 30, 2014 or December 31, 2013.

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.

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NOTE 10: COMPREHENSIVE INCOME

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

				Unrealized
				Gains
				(Losses) on
				Securities
	Unrealized			Transferred
	Gains (Losses)			From									Accumulated
	on Securities			Available-For-									Other
	Available-For-			Sale to Held-			Pension			Interest Rate			Comprehensive
(In thousands)	Sale			To-Maturity			Plan			Swaps			Income (Loss)
Balance June 30, 2014	$	1,436		$	(3,064)		$	(1,748)		$	(407)		$	(3,783)
Other comprehensive income before reclassifications		(589)			-			-			66			(523)
Accretion of unrealized losses of securities transferred from available-for-sale to held-to-maturity recognized in other comprehensive income		-			127			-			-			127
Reclassification adjustments for (gains) losses reclassified into income		24			-			21			-			45
Net current period other comprehensive income		(565)		-	127			21			66			(351)
Balance September 30, 2014	$	871		$	(2,937)		$	(1,727)		$	(341)		$	(4,134)
Beginning Balance December 31, 2013	$	(162)		$	(3,296)		$	(1,790)		$	(472)		$	(5,720)
Other comprehensive income before reclassifications		1,110			-			-			131			1,241
Transfer of securities from available-for-sale to held-to-maturity		(8)			8			-			-			-
Accretion of unrealized losses of securities transferred from available-for-sale to held-to-maturity recognized in other comprehensive income		-			351			-			-			351
Reclassification adjustments for (gains) losses reclassified into income		(69)			-			63			-			(6)
Net current period other comprehensive income		1,033			359			63			131			1,586
Balance September 30, 2014		$	871		$	(2,937)		$	(1,727)		$	(341)		$	(4,134)

All amounts in the tables above are net of tax. Amounts in parentheses indicate debits.

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Details of amounts reclassified from accumulated comprehensive income for the three and nine months ended September 30, 2014 and  2013 are presented below:

	Three Months		Nine Months
Details about Accumulated Other	Ended		Ended
Comprehensive Income Components	September 30,		September 30,		Affected Line Item in the Statement
(In thousands)	2014		2014		Where Net Income is Presented
Unrealized gains on securities	$	37	$	(106)	Net (gains) losses on investment securities
		37		(106)	Total before tax
		(13)		37	Provision for income taxes
	$	24	$	(69)	Net of tax
Pension and postretirement benefit plans	$	31	$	97	Compensation and benefits
		31		97	Total before tax
		(10)		(34)	Provision for income taxes
	$	21	$	63	Net of tax
Total reclassification adjustments	$	45	$	(6)

	Three Months		Nine Months
Details about Accumulated Other	Ended		Ended
Comprehensive Income Components	September 30,		September 30,		Affected Line Item in the Statement
(In thousands)	2013		2013		Where Net Income is Presented
Unrealized gains on securities	$	(1)	$	12	Net (gains) losses on investment securities
		(1)		12	Total before tax
		1		(4)	Provision for income taxes
	$	-	$	8	Net of tax
Pension and postretirement benefit plans	$	87	$	266	Compensation and benefits
		87		266	Total before tax
		(30)		(93)	Provision for income taxes
	$	57	$	173	Net of tax
Total reclassification adjustments	$	57	$	181

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NOTE 11: DERIVATIVE FINANCIAL INSTRUMENTS

At September 30, 2014 and December 31, 2013, we had an interest rate swap with a notional amount of $10 million that was designated as a cash flow hedge. The swap was used to convert a portion of the floating rate interest on our trust preferred issuance to a fixed rate of interest. Each quarter we assess the effectiveness of the hedging relationships by comparing the changes in cash flows of the derivative hedging instruments with the changes in cash flows of the designated hedged item. There was no ineffective portion recognized in earnings during the three and nine months ended September 30, 2014 or September 30, 2013. The fair value of $(524) thousand and $(726) thousand was reflected in other comprehensive income in the accompanying consolidated balance sheets at September 30, 2014 and December 31, 2013, respectively.

We are party to interest rate swaps with a notional amount of $40.2 million with certain of our commercial customers.  In order to minimize our risk, these customer derivatives (pay floating/receive fixed swaps) have been offset with essentially matching interest rate swaps with our counterparty totaling $40.2 million (pay fixed/receive floating swaps). At September 30, 2014, the weighted average receive rate of these interest rate swaps was 1.84%, the weighted average pay rate was 3.63% and the weighted average maturity was 12.3 years.  The fair values of $381 thousand were reflected in other assets and other liabilities, respectively, in the accompanying consolidated balance sheets at September 30, 2014.  The fair values of $803 thousand were reflected in other assets and other liabilities, respectively, in the accompanying consolidated balance sheets at December 31, 2013.  Hedge accounting has not been applied for these derivatives.  Because the terms of the swaps with our customer and the other financial institution offset each other, with the only difference being counterparty credit risk, changes in the fair value of the underlying derivative contracts are not materially different and do not significantly impact our results of operations.

We are party to interest rate swaps with notional amounts totaling $9.36 million that were designated as fair value hedges of certain fixed rate loans with municipalities. At September 30, 2014, the weighted average receive rate of these interest rate swaps was 1.54%, the weighted average pay rate was 3.26% and the weighted average maturity was 17.8 years. The amounts recognized in earnings and other assets for the ineffective portion of the interest swaps were immaterial.

We assessed our counterparty risk at September 30, 2014 and determined any credit risk inherent in our derivative contracts was insignificant. Information about the fair value of derivative financial instruments can be found in Note 5 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 Merchants’ 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, 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 non-interest income; changes in the domestic interest rate environment and inflation; changes in the carrying value of investment securities and other assets; misalignment of our interest-bearing assets and liabilities; increases in loan repayment rates affecting interest income and the value of mortgage servicing rights; 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, declines in consumer confidence in depository institutions, 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 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contains financial information determined by methods other than in accordance with accounting principles generally accepted in the United States of America (“GAAP”).  We use these “non-GAAP” measures in our analysis of our performance and believe that these non-GAAP financial measures provide a greater understanding of ongoing operations and enhance comparability of our results with prior periods and with the results of other financial institutions. 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. 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 2014 and 2013. An additional non-GAAP financial measure we use is the tangible capital ratio. Because we have no intangible assets, our tangible shareholder’s equity is the same as our shareholder’s equity.

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GENERAL

The following discussion and analysis of financial condition as of September 30, 2014 and December 31, 2013 and results of operations of Merchants and its subsidiaries for the three and nine months ended September  30, 2014 and 2013 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 $2.81 million and $9.62 million, or diluted earnings per share of $0.44 and $1.52 for the three and nine months ended September 30, 2014, respectively.  This compares to net income of $3.67 million and $11.31 million, or diluted earnings per share of $0.58 and $1.79 for the three and nine months ended September 30, 2013, respectively. The return on average assets was 0.68% and 0.77% for the three and nine months ended September 30, 2014, respectively, compared to 0.88% and 0.90% for the same periods in 2013. The return on average equity was 9.02% and 10.48% for the three and nine months ended September 30, 2014, respectively, compared to 12.89% and 12.94% for the same periods in 2013. We declared and distributed dividends of $0.28 and $0.84 per share during the three and nine months ended September 30, 2014, respectively. We declared a dividend of $0.28 per share, payable November 13, 2014, to shareholders of record as of October 30, 2014.

Shareholders’ equity ended the quarter at $125.74 million, and our book value per share increased to $19.86 per share at September 30, 2014 from $18.93 at December 31, 2013.  Our capital ratios remain strong at September 30, 2014. Our capital ratios remain strong, with a Tier 1 leverage ratio of 8.95%, a total risk-based capital ratio of 17.29% and a tangible capital ratio of 7.63%.  At September 30, 2014 our Tier 1 leverage ratio was 8.95%, total risk-based capital ratio was 17.29% and our tangible capital ratio was 7.63%.

Ø Net interest income - Our taxable equivalent net interest income was $12.01 million and $36.50 million for the three and nine months ended September 30, 2014, respectively, compared to $12.71 million and $38.24 million for the same periods in 2013.  Our taxable equivalent net interest margin was 3.03% and 3.07% for the quarter and nine months ended September 30, 2014, compared to 3.14% and 3.17% for the same periods in 2013.

Ø Provision for Credit Losses – We did not book a provision for credit losses for the third quarter of 2014.  Asset quality continues to improve and net charge-offs were negligible.

Ø Loans - Quarterly average loan balances for the third quarters of 2014 and 2013 were $1.16 billion and $1.15 billion, respectively, and ending loan balances were $1.16 billion and $1.17 billion at September 30, 2014 and September 30, 2013, respectively.  

Ø Deposits – Quarterly average deposits for the third quarters of 2014 and 2013 were $1.34 billion and ending deposit balances were $1.30 billion and $1.33 billion at September 30, 2014 and 2013, respectively.

Ø Non-interest income - Total noninterest income increased $90 thousand to $2.88 million for the third quarter of 2014 compared to the third quarter of 2013 and increased $537 thousand for the first nine months of 2014 compared to the first nine months of 2013.

Ø Non-interest expense – Total noninterest expense increased $1.10 million to $10.72 million for the third quarter of 2014 compared to the same period in 2013. Excluding core system conversion costs of $442 thousand and a severance accrual of $410 thousand total noninterest expense increased $244 thousand for the third quarter of 2014 compared to the same period in 2013. 

Net Interest Income

As shown on the tables on pages 31 and 32, our taxable equivalent net interest income was $12.01 million and $36.50 million for the three and nine months ended September 30, 2014, respectively, compared to $12.71 million and $38.24 million for the same periods in 2013.   Our taxable equivalent net interest margin was 3.03% and 3.07% for the quarter and nine months ended September 30, 2014, compared to 3.14% and 3.17% for the same periods in 2013. The margin decreased by three basis points during the third quarter of 2014 and has decreased by seven basis points over the course of 2014.  We have continued to increase balance sheet liquidity  and  reduce  price  volatility  exposure  in  our  investment  portfolio  by  allowing  the investment portfolio to run off and holding a larger percentage of our balance sheet in cash, which has compressed asset yields.  These changes have shortened our assets and caused us to give up some current income, but have reduced price volatility exposure on our balance sheet and better positioned us for rising rates. At the same time our loan yields have continued to compress due to a combination of the extended low interest rate environment, tighter credit spreads and competitive  pressures.   Additionally, we have continued to increase our variable rate loan portfolio.   Average variable rate loans for the third quarter of 2014 were $321.33 million, a $17.27 million increase over the third quarter of 2013.  These loans have a lower current yield than fixed rate loans, but will have higher yields when rates start to rise.

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The following tables present an analysis of net interest income and illustrate 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 basis, using a 35% rate.  Nonaccrual loans are included in the average loan balance outstanding.

	Three Months Ended
	September 30, 2014			September 30, 2013
		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	$    1,162,236	$     11,151	3.81%	$    1,154,967	$    11,631	4.00%
Investments	341,165	1,885	2.19%	427,414	2,301	2.14%
Interest-earning deposits with banks and other short-term investments	72,400	37	0.20%	21,700	13	0.24%
Total interest earning assets	1,575,801	$     13,073	3.29%	1,604,081	13,945	3.45%
Allowance for loan losses	(12,090)			(11,946)
Cash and due from banks	27,871			27,913
Bank premises and equipment, net	15,923			16,392
Bank owned life insurance	10,190			-
Other assets	24,695			25,077
Total assets	$    1,642,390			$    1,661,517
LIABILITIES AND SHAREHOLDERS' EQUITY:
Interest-bearing deposits:
Savings, interest bearing checking and money market accounts	$       612,811	$          370	0.24%	$       772,234	$         416	0.21%
Time deposits	247,297	433	0.70%	318,795	532	0.66%
Total interest bearing deposits	860,108	803	0.37%	1,091,029	948	0.34%
Short-term borrowings	96	0	0.00%	26,451	21	0.32%
Securities sold under agreements to repurchase, short-term	152,451	62	0.16%	145,962	62	0.17%
Other long-term debt	2,348	12	2.04%	2,430	12	2.04%
Junior subordinated debentures issued to unconsolidated subsidiary trust	20,619	189	3.71%	20,619	189	3.71%
Total borrowed funds	175,514	263	0.60%	195,462	284	0.58%
Total interest bearing liabilities	1,035,622	$       1,066	0.41%	1,286,491	$      1,232	0.38%
Noninterest bearing deposits	475,101			252,795
Other liabilities	7,250			8,150
Shareholders' equity	124,417			114,081
Total liabilities and shareholders' equity	$    1,642,390			$    1,661,517
Net interest earning assets	$       540,179			$       317,590
Net interest income (fully taxable equivalent)		$     12,007			$    12,713
Tax equivalent adjustment		(509)			(561)
Net interest income		$     11,498			$    12,152
Net interest rate spread			2.88%			3.07%
Net interest margin			3.03%			3.14%

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	Nine Months Ended
	September 30, 2014			September 30, 2013
		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	$    1,166,197	$     33,727	3.86%	$    1,121,404	$    34,392	4.10%
Investments	360,790	6,145	2.28%	470,911	7,649	2.17%
Interest-earning deposits with banks and other short-term investments	64,328	110	0.23%	21,265	38	0.24%
Total interest earning assets	1,591,315	$     39,982	3.36%	1,613,580	42,079	3.49%
Allowance for loan losses	(12,138)			(11,827)
Cash and due from banks	27,646			26,232
Bank premises and equipment, net	15,578			16,368
Bank owned life insurance	10,110			0
Other assets	26,858			30,373
Total assets	$    1,659,369			$    1,674,726
LIABILITIES AND SHAREHOLDERS' EQUITY:
Interest-bearing deposits:
Savings, interest bearing checking and money market accounts	$       715,869	$       1,283	0.24%	$       727,042	$         758	0.14%
Time deposits	271,062	1,358	0.67%	325,718	1,664	0.68%
Total interest bearing deposits	986,931	2,641	0.36%	1,052,760	2,422	0.31%
Short-term borrowings	283	-	0.00%	23,009	51	0.29%
Securities sold under agreements to repurchase, short-term	181,002	241	0.18%	212,755	766	0.48%
Other long-term debt	2,369	37	2.09%	2,450	37	2.03%
Junior subordinated debentures issued to unconsolidated subsidiary trust	20,619	561	3.70%	20,619	565	3.73%
Total borrowed funds	204,273	839	0.55%	258,833	1,419	0.73%
Total interest bearing liabilities	1,191,204	$       3,480	0.39%	1,311,593	$      3,841	0.39%
Noninterest bearing deposits	337,546			238,655
Other liabilities	8,204			7,952
Shareholders' equity	122,415			116,526
Total liabilities and shareholders' equity	$    1,659,369			$    1,674,726
Net interest earning assets	$       400,111			$       301,987
Net interest income (fully taxable equivalent)		$     36,502			$    38,238
Tax equivalent adjustment		(1,567)			(1,528)
Net interest income		$     34,935			$    36,710
Net interest rate spread			2.97%			3.10%
Net interest margin			3.07%			3.17%

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The following tables present 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
	September 30,		Increase	Due to
(In thousands)	2014	2013	(Decrease)	Volume	Rate	Volume/Rate
Fully taxable equivalent interest income:
Loans	$         11,151	$         11,631	$             (480)	$             73	$            (531)	$             (22)
Investments	1,885	2,301	(416)	(464)	61	(13)
Interest earning deposits with banks and other short-term investments	37	13	24	30	(2)	(4)
Total interest income	13,073	13,945	(872)	(361)	(472)	(39)
Less interest expense:
Savings, interest bearing checking and money market accounts	370	416	(46)	(86)	51	(11)
Time deposits	433	532	(99)	(119)	27	(7)
FHLB and other short-term borrowings	0	21	(21)	(21)	-	-
Securities sold under agreements to repurchase, short-term	62	62	(0)	3	(3)	-
Other long-term debt	12	12	-	-	-	-
Junior subordinated debentures issued to unconsolidated subsidiary trust	189	189	-	-	1	(1)
Total interest expense	1,066	1,232	(166)	(223)	76	(19)
Net interest income	$         12,007	$         12,713	$             (706)	$           (138)	$            (548)	$             (20)

	Nine Months Ended
	September 30,		Increase	Due to
(In thousands)	2014	2013	(Decrease)	Volume	Rate	Volume/Rate
Fully taxable equivalent interest income:
Loans	$         33,727	$         34,392	$             (665)	$        1,374	$         (1,976)	$             (63)
Investments	6,145	7,649	(1,504)	(1,787)	377	(94)
Interest earning deposits with banks and other short-term investments	110	38	72	77	(2)	(3)
Total interest income	39,982	42,079	(2,097)	(336)	(1,601)	(160)
Less interest expense:
Savings, interest bearing checking and money market accounts	1,283	758	525	(12)	542	(5)
Time deposits	1,358	1,664	(306)	(278)	(25)	(3)
FHLB and other short-term borrowings	-	51	(51)	(51)	-	-
Securities sold under agreements to repurchase, short-term	241	766	(525)	(114)	(480)	69
Other long-term debt	37	37	0	(1)	1	-
Junior subordinated debentures issued to unconsolidated subsidiary trust	561	565	(4)	-	(20)	16
Total interest expense	3,480	3,841	(361)	(456)	18	77
Net interest income	$         36,502	$         38,238	$          (1,736)	$           120	$         (1,619)	$           (237)

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Provision for Credit Losses

We did not record a provision for credit losses during the third quarter of 2014, and year to date we have recorded a $150 thousand  provision for credit losses compared to $400 thousand and $800 thousand for the three and nine months ended  September 30, 2013.  Credit quality improved further during the quarter.  Our nonperforming loans were 0.02% of total loans at September 30, 2014, and loans past due 30-89 days were 0.01% of total loans at September 30, 2014. Net charge-offs during 2014 have been negligible. For a more detailed discussion of the Allowance and nonperforming assets, see “Credit Quality and Allowance for Credit Losses” beginning on page 35.

NONINTEREST INCOME AND EXPENSES

Noninterest income

Total noninterest income increased $90 thousand to $2.88 million for the third quarter of 2014 compared to the third quarter of 2013 and increased $537 thousand for the first nine months of 2014 compared to the first nine months of 2013. Excluding net gains (losses) on investment securities, total noninterest income increased $128 thousand and $419 thousand for the third quarter and first nine months of 2014, respectively, compared to the same periods in 2013.   Trust division income increased $97 thousand and $259 thousand for the three and nine months ended September 30, 2014, respectively, compared to the same periods in 2013 as trust division assets under management have continued to show strong growth and now total $628 million. Service charges on deposits increased $40 thousand and $83 thousand for the three and nine months ended September 30, 2014 compared to the same periods in 2013, a result of an increase in cash management fees and business checking service charges.   We continue to experience pressure on our overdraft and net debit card fee income.

Noninterest expense

Total noninterest expense increased $1.10 million to $10.72 million for the third quarter of 2014 compared to the same period in 2013 and increased $2.02 million to $30.97 million for the first nine months of 2014 compared to the same period in 2013. We absorbed $442 thousand and $830 thousand in core conversion expenses during the three and nine months ended September 30, 2014.  Excluding core conversion expenses and a one-time $410 thousand severance accrual recorded during the third quarter, total noninterest expenses increased $244 thousand and $779 thousand for the three and nine months ended September 30, 2014.  In total, we expect to incur approximately $1.30 million in expenses related to the core conversion during 2014 and expect to realize annual cost savings and additional revenue opportunities of approximately $800 thousand starting in November of this year.

Compensation and benefits increased $391 thousand and $847 thousand for the three and nine months ended September 30, 2014, respectively, compared to the same periods in 2013. The increase was a result of additional investments we have made in the Finance and Risk areas combined with lower credits related to loan originations, as well as the previously mentioned severance accrual. Occupancy and equipment costs were $132 thousand higher for the third quarter of 2014 compared to 2013, and were $359 thousand higher for the first three quarters of 2014 compared to 2013, a result of investments we have made recently to update, and in some cases, combine our facilities.  Marketing expenses for the third quarter of 2014 were $521 thousand, $128 thousand higher than the third quarter of 2013, and were $1.16 million year to date, unchanged from the first nine months of 2013.

Income Taxes

During the first quarter of 2014 we adopted, and applied retrospectively, Financial Accounting Standards Board Accounting Standards Update 2014-01, “Accounting for Investments in Qualified Affordable Housing Projects” which allows investors in low income housing tax credit entities that meet certain conditions to account for the investments entirely in income tax expense, which we believe more accurately reflects the economics of the investment.  The application of this standard reduced total noninterest expense by $327 thousand and $981 thousand for the quarter and nine months ended September 30, 2014, respectively; and by $271 thousand and $811 thousand for the quarter and nine months ended September 30, 2013, respectively and increased income tax expense by an equivalent amount.  The application of the standard also increased our effective tax rate to 23% from 16%  and 17% for the three months and nine months ended September 30, 2014, respectively, and to 25% from 21% for the three and nine months ended September 30, 2013, respectively.

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BALANCE SHEET ANALYSIS

Loans

Quarterly average loan balances for the third quarter of 2014 were $1.16 billion, $7.27 million higher than quarterly average balances for the third quarter of 2013, but $7.70 million lower than quarterly average balances for the fourth quarter of last year. Loan balances reflect modest origination activity which was more than offset by amortization and prepayments.

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

(In thousands)		September 30, 2014		June 30, 2014		December 31, 2013		September 30, 2013
Commercial, financial and agricultural	$	183,069	$	193,806	$	172,810	$	163,138
Municipal loans		96,258		46,358		94,007		96,491
Real estate loans – residential		472,986		476,696		489,706		493,667
Real estate loans – commercial		381,301		372,825		371,319		373,085
Real estate loans – construction		17,970		32,336		31,841		32,768
Installment loans		4,793		4,238		5,655		5,898
All other loans		286		252		895		454
Total loans	$	1,156,663	$	1,126,511	$	1,166,233	$	1,165,501

Totals above are shown net of deferred loan fees of $646 thousand, $582 thousand, $618 thousand, and $561 thousand for September 30, 2014, June 30, 2014, December 31, 2013, and September 30, 2013, respectively. 

Investments

The investment portfolio is used to generate interest income, manage liquidity and mitigate interest rate sensitivity. The  average  investment  portfolio  for  the  third  quarter  of  2014  was  $336.29 million,  a  reduction  of $66.71 million from average balances for the fourth quarter of 2013.  The ending balance in the investment portfolio at September 30, 2014 was $328.16 million, compared to $335.44 million at June 30, 2014 and $393.34 million at December 31, 2013. The book balance of the portfolio at September 30, 2014 includes a $1.37 million unrealized gain on the available for sale portion of the investment portfolio, compared to an unrealized loss of ($220) thousand at December 31, 2013. Interest rates have trended down over the course of 2014 which has positively impacted the value of our largely fixed rate investment portfolio.  We sold $14.35 million in securities during the quarter for a small loss.  We sold bonds that had higher than average price volatility and lower than average yields to continue to reduce the exposure to rising rates and the risk to tangible capital in the investment portfolio. We also took advantage of an opportunity to unwind our remaining CLO portfolio.    

The composition of our investment portfolio as of September 30, 2014, including both available for sale and held to maturity securities, consisted of the following:

		Amortized		Fair
(In thousands)		Cost		Value
Available for Sale:
U.S. Treasury Obligations	$	20,057	$	20,017
Residential Real Estate Mortgage-backed Securities ("Agency MBSs")		87,162		89,267
Agency Commercial Mortgage Backed Securities ("Agency CMBSs")		17,988		17,460
Non-agency Collateralized Mortgage Obligations ("Non-agency CMOs")		59,118		58,917
Asset Backed Securities ("ABSs")		353		388
Total Available for Sale	$	184,678		186,049
Held to Maturity:
U.S. Agency Obligations		22,259		22,379
U.S. Government Sponsored Enterprises ("U.S. GSEs")		9,483		9,335
Federal Home Loan Bank ("FHLB") Obligations		4,711		4,712
Agency Collateralized Mortgage Obligations		8,347		8,464
Agency MBSs		97,310		95,521
Total Held to Maturity		142,110		140,411
Total Securities	$	326,788	$	326,460

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 CMBSs consist of bonds backed by commercial real estate which are guaranteed by FNMA.

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. 

Deposits and Other Liabilities

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Quarterly average deposits for the third quarter of 2014 were $1.34 billion, an $8.62 million decrease compared to quarterly average deposits for the third quarter of 2013. Growth in business demand deposits and retail money market categories has been offset by reduced time deposit balances. During the quarter we reduced our interest rate on our free checking for life accounts from 0.01% to zero and reclassed balances totaling $214.93 million at September 30, 2014 from interest bearing deposits to noninterest bearing deposits. Average securities sold under agreement to repurchase, which represent collateralized customer accounts, declined to $152.45 million at September 30, 2014 from $212.31 million at December 31, 2013 as a result of seasonal municipal cash flows; average balances were $6.49 million higher compared to the third quarter of 2013.

CREDIT QUALITY AND ALLOWANCE FOR CREDIT LOSSES

The United States economy continues to show improvement into 2014; however, high unemployment and foreclosure rates continue 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 pool of nonperforming loans is dynamic with accounts moving in and out of this category over time.

The following table summarizes our nonperforming loans and nonperforming assets as of the dates indicated:

(In thousands)		September 30, 2014		June 30, 2014		December 31, 2013		September 30, 2013
Nonaccrual loans	$	308	$	372	$	425	$	2,236
Loans past due 90 days or more and still accruing		-		79		75		83
Troubled debt restructurings ("TDR")		424		437		406		365
Total nonperforming loans ("NPL")		732		888		906		2,684
OREO		-		-		108		23
Total nonperforming assets ("NPA")	$	732	$	888	$	1,014	$	2,707

Non-performing loans at September  30, 2014 were $732 thousand, 0.06% of total loans. Of the $732 thousand in nonperforming loans in the table above, $219 thousand are commercial and commercial real estate loans and $513 thousand are residential mortgages and home equity loans. 

We originate traditional mortgage and home equity products that are fully documented and underwritten. We take a proactive risk management approach by conducting periodic stress-testing of the existing residential loan portfolio and adjusting underwriting requirements, if necessary, based upon the results of the analysis. The assumptions used in the stress testing include: credit score migration; calculation of possible losses using conservative assumptions of market decline; review of life-of-loan delinquency levels relative to loan size and credit score; analysis of the portfolio by loan size, and distribution within the portfolio by loan-to-value ratios. Based upon the results of assessments of the residential loan portfolio, Management concluded that current reserve levels were adequate.

Our analysis indicates that, through a combination of estimated collateral value and, where needed, an appropriately allocated reserve, any additional loss exposure on current non-accruing loans is minimal. 

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. At September 30, 2014, $222 thousand of TDRs were in nonaccrual status and $202 thousand were accruing interest. 

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

Period Ended	30-89 Days
September  30, 2014	0.02%
June  30, 2014	0.01%
December 31, 2013	0.03%
September 30, 2013	0.01%

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

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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 three 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 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 statements of income. Impaired loans, which primarily consist of non-accruing residential mortgage and commercial real estate loans and TDRs, totaled $732 thousand and $906 thousand at September 30, 2014 and December 31, 2013, respectively.  At September 30, 2014, impaired loans with a recorded investment were $310 thousand and had specific reserve allocations totaling $100 thousand. 

Substandard loans at September 30, 2014 totaled $25.23 million, of which $24.83 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 September 30, 2014 reflect a $400 thousand decrease in balances since December 31, 2013. At September 30, 2014, accruing substandard loans related to owner-occupied commercial and construction real estate totaled $16.73 million, investor commercial real estate loans totaled $1.23 million, residential mortgage loans totaled $4 thousand, residential investment real estate loans totaled $1.28 million, and $5.59 million in substandard loans are outstanding to corporate borrowers in a variety of different industries. Eleven borrowers in a variety of industries account for 85% of the total accruing substandard loans, and approximately $659 thousand of the total accruing substandard loans carry some form of government guarantee.

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

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 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 probable incurred losses 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 adjusted for qualitative factors and assigns a required allocation by loan classification based on a fixed percentage of all outstanding loan balances. The general allowance

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

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

		Three Months		Nine Months		Three Months		Nine Months
		Ended		Ended		Ended		Ended
(In thousands)		September 30, 2014		September 30, 2014		September 30, 2013		September 30, 2013
Average loans during the period	$	1,162,236	$	1,166,197	$	1,154,967	$	1,121,404
Allowance beginning of the year		12,906		12,828		12,658		12,312
Charge-offs:
Commercial, financial & agricultural		-		(34)		-		-
Real estate - residential		(7)		(25)		(49)		(152)
Real estate - commercial		-		-		-		(1)
Other		(48)		(99)		(36)		(84)
Total charge-offs		(55)		(158)		(85)		(237)
Recoveries:
Commercial, financial & agricultural		-		3		13		62
Real estate - residential		-		20		-		4
Real estate - commercial		-		-		-		40
Real estate - construction		-		-		1		2
Installment		-		1		-		-
Other		7		14		4		8
Total recoveries		7		38		18		116
Net recoveries (charge-offs)		(48)		(120)		(67)		(121)
Provision for credit losses		-		150		400		800
Allowance end of year	$	12,858	$	12,858	$	12,991	$	12,991
Ratio of net (charge-offs) recoveries to average loans outstanding		(0.02)%		(0.01)%		(0.02)%		(0.01)%
Components:
Allowance for loan losses	$	12,019	$	12,019	$	12,199	$	12,199
Reserve for undisbursed lines of credit		839		839		792		792
Allowance for credit losses	$	12,858	$	12,858	$	12,991	$	12,991

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

	September 30, 2014	June 30, 2014	December 31, 2013
NPL to total loans	0.06%	0.08%	0.08%
NPA to total assets	0.04%	0.06%	0.06%
Allowance for loan losses to total loans	1.04%	1.07%	1.03%
Allowance for loan losses to NPL	1642%	1356%	1329%

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 experience. Loan requests that exceed a lender's authority require the signature of our Senior Lender, the Senior Credit Officer, and/or our President. With the exception of certain municipal loans, all extensions of credit of $5.0 million or greater to

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any one borrower, or related party interest, are reviewed and approved by the Loan Committee of Merchants Bank’s Board of Directors. Short-term revenue anticipation and tax anticipation extensions of credit of $8.0 million or greater to a municipality are reviewed and approved by the Loan Committee of Merchants Bank’s Board of Directors.

The Loan Committee and the credit department regularly monitor our loan portfolio. The entire loan portfolio, as well as individual loans, is reviewed for loan performance, compliance with internal policy requirements and banking regulations, creditworthiness, and strength of documentation. We monitor loan concentrations by individual borrowers, industries and loan types. As part of the annual credit policy review process, targets are set by loan type for the total portfolio. Credit risk ratings assessing inherent risk in individual loans are assigned to commercial loans at origination and are 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 loan review firms to assist in monitoring the commercial, municipal and residential loan portfolios. The commercial loan review firm annually reviews, at a minimum, 60% in dollar volume of our commercial loan portfolio and certain transactions based on amount and maturity date for our municipal loan portfolio. 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 and investment 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 September 30, 2014, we could borrow up to $65 million in overnight funds through unsecured borrowing lines established with correspondent banks.  We have established both overnight and longer term lines of credit with the 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 $265.68 million at September 30, 2014. We have additional borrowing capacity with the FHLBB of $249.16 million as of September 30, 2014.  We have also established a borrowing facility with the Board of Governors of the Federal Reserve System (“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 MBSs and Agency CMOs, with certain approved counterparties. Our investment portfolio, which is managed by the ALCO, has a cost basis of $326.79 million at September 30, 2014, of which $254.67 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 left on deposit at the FRB.

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

		Three Months		Nine Months
		Ended		Ended
(In thousands)		September 30, 2014		September 30, 2014
FHLBB and other short-term borrowings
Amount outstanding at end of period	$	-	$	-
Maximum during the period amount outstanding		4,400		18,900
Average amount outstanding		96		283
Weighted-average rate during the period		0.36%		0.31%
Weighted-average rate at period end		0.00%		0.00%
Securities sold under agreement to repurchase, short-term
Amount outstanding at end of period	$	188,157	$	188,157
Maximum during the period amount outstanding		203,996		247,153
Average amount outstanding		152,451		181,002
Weighted-average rate during the period		0.16%		0.18%
Weighted-average rate at period end		0.17%		0.17%

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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 $7.58 million and $5.02 million at September 30, 2014 and September 30, 2013, 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 September 30, 2014 and 2013 was insignificant.

Capital Resources

We are subject to various regulatory capital requirements administered by federal banking agencies. Failure to meet minimum capital requirements results in certain mandatory, and the possibility  of additional discretionary, actions by regulators that could have a direct material effect on our financial statements. Under capital adequacy guidelines, we must meet specific capital guidelines that involve quantitative measures of our assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. It is the policy of the FRB that banks and bank holding companies 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 us to meet specific capital guidelines to be considered well capitalized. Our capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

Quantitative measures established by regulation to ensure capital adequacy require us to maintain minimum ratios (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 September 30, 2014, that Merchants met all capital adequacy requirements to which it is subject.

As of September 30, 2014, 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. We continue to be considered well capitalized under current applicable regulations.

The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) required the federal banking agencies to establish minimum leverage and risk-based capital requirements for insured banks and their holding companies.  The federal banking agencies issued a joint final rule, or the “Final Capital Rule,” that implements the Basel III capital standards and establishes the minimum capital levels required under the Dodd-Frank Act.  We must comply with the Final Capital Rule by January 1, 2015.  The Final Capital Rule establishes a minimum common equity Tier 1 capital ratio of 6.5% of risk-weighted assets for a “well capitalized” institution and increases the minimum Tier 1 capital ratio for a “well capitalized” institution from 6% to 8%. Additionally, the Final Capital Rule requires an institution to maintain a 2.5% common equity Tier 1 capital conservation buffer over the 6.5% minimum risk-based capital requirement to avoid restrictions on the ability to pay dividends, discretionary bonuses, and engage in share repurchases.  The Final Capital Rule permanently grandfathers trust preferred securities issued before May 19, 2010, subject to a limit of 25% of Tier 1 capital.  As of September 30, 2014, our capital ratios exceed all Basel III minimums, including the capital conservation buffer.

The following table represents our actual capital ratios and capital adequacy requirements as of September 30, 2014.

					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	$      146,942	8.95%	$        65,696	4.00%	N/A	N/A
Tier 1 Risk-Based Capital	146,942	16.04%	36,640	4.00%	N/A	N/A
Total Risk-Based Capital	158,409	17.29%	73,280	8.00%	N/A	N/A
Merchants Bank:
Tier 1 Leverage Capital	$      144,594	8.79%	$        65,820	4.00%	$        82,275	5.00%
Tier 1 Risk-Based Capital	144,594	15.68%	36,892	4.00%	55,339	6.00%
Total Risk-Based Capital	156,139	16.93%	73,785	8.00%	92,231	10.00%

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 in compliance with our Liquidity Contingency Plan.

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 (“ALCO”), which delegates responsibility for carrying out the asset/liability management policies to the Management-level Asset and Liability Committee (“Management ALCO”). The Management ALCO, chaired by the Chief Financial Officer and composed of members of senior management, develops guidelines and strategies impacting our asset and liability management-related activities based upon estimated market risk sensitivity, policy limits and overall market interest rate levels and trends. The Management ALCO manages the investment portfolio. 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 Management 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 Management 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 Management 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 maturities and pricing of loans and deposits. The Management 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 and monitoring their financial condition.  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 September 30, 2014. 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.  The consultant also ran simulations in a 400 basis points rising scenario and a 500 basis point flattening scenario. Additionally, the consultant ran simulations with other changes in the yield curve and with prepayment speed changes.  A summary of the results is as follows:

Current/Flat Rates: If rates remain at current levels net interest income is projected to trend downward for the entire simulation as asset yields will continue to decline while funding costs provide little to no relief.

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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 year as we bring funding costs down to near zero.  Thereafter net interest income is reduced as increased prepayment speeds accelerate asset cash flow putting added pressure on asset yields, while deposit rate reductions are limited as they are at or near their floors. 

Rising Rates: Higher rates are better for us under all scenarios. If rates rise in a parallel fashion net interest income rises above the base case immediately and continues to increase throughout the simulation as asset yields improve and outpace assumed funding costs increases.  This asset sensitivity holds true even if the yield curve were to flatten as rates rise.   

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 September 30, 2014 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	3.7%
Down 100 basis points	0.3%

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 (3.9)% and (10.6)%, respectively, while the up 200 basis points simulation produces an increase of 7.5%.  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 September 30, 2014 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 experience. Loan requests that exceed a lender’s authority require the signature of our Credit Division Manager, Senior Loan Officer, and/or President. With the exception of certain municipal loans, all extensions of credit of $5.0 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. Short-term revenue anticipation and tax anticipation extensions of credit of $8.0 million or greater to a municipality are reviewed and approved by the Loan Committee of Merchants Bank’s 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 loans when scheduled payments become contractually past due 90 or more days and the ultimate collectability of principal or interest becomes doubtful.  In certain instances the accrual of interest is discontinued prior to 90 days past due if Management determines that the borrower will not be able to continue making timely payments.

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Item 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 September 30, 2014 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

In addition to the other information set forth in this report, please read the factors discussed in Part I – Item 1A, "Risk Factors" in our Annual Report on Form 10-K for the fiscal year ended December 31, 2013 filed with the SEC on March 10, 2014, which could materially adversely affect our business, financial condition and operating results. These risks are not the only ones facing us. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and operating results.

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

None.

Item 3. Defaults Upon Senior Securities

None.

Item 4. Mine Safety Disclosure

Not applicable.

Item 5. Other Information

None. 

Item 6. Exhibits

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

31.2* Certification of Chief Financial Officer Pursuant to Rules 13a-14(a) and 15d-14(a) 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 September 30, 2014 formatted in XBRL: (i) Consolidated Balance Sheets at September 30, 2014 and December 31, 2013; (ii) Consolidated Statements of Income for the three and nine months ended September 30, 2014 and 2013; (iii) Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2014 and 2013; (iv) Consolidated Statements of Cash Flows for the nine months ended September 30, 2014 and 2013; 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

October 30, 2014

Date

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