Merrill Merchants Bancshares (MERB) 10-Q 2006 Q3 Quarterly report

FORM 10-Q

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2006

Commission File Number: 0-24715

MERRILL MERCHANTS BANCSHARES, INC.

(Exact name of registrant as specified in its charter)

MAINE	01-0471507
(State or other jurisdiction of	(IRS Employer Identification No.)
incorporation or organization)

201 Main Street

Bangor, Maine 04401

(Address of principal executive offices)

Registrant’s telephone number, including area code: 207-942-4800

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 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. Yes: x No: o

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

Large accelerated filer o Accelerated filer o Non-accelerated filer x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes: o No: x

The number of shares outstanding of the issuer's common stock as of October 31, 2006 is 3,550,510.

MERRILL MERCHANTS BANCSHARES, INC.

INDEX TO FORM 10-Q

PART I FINANCIAL INFORMATION	Page
ITEM 1. FINANCIAL STATEMENTS
Report of Independent Registered Public Accounting Firm	3
Consolidated Statements of Financial Condition at September 30, 2006 and December 31, 2005	4
Consolidated Statements of Income for the Three and Nine Months Ended
September 30, 2006 and 2005	5
Consolidated Statements of Changes in Shareholders' Equity for the Nine Months Ended
September 30, 2006 and 2005	6
Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2006 and 2005	7
Notes to Consolidated Financial Statements	8
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS	9
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	16
ITEM 4. CONTROLS AND PROCEDURES	17
PART II OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS	18
ITEM 1A. RISK FACTORS	18
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	18
ITEM 3. DEFAULTS UPON SENIOR SECURITIES	18
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS	18
ITEM 5. OTHER INFORMATION	18
ITEM 6. EXHIBITS	20
SIGNATURE PAGE	21
EXHIBITS

2

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Shareholders

Merrill Merchants Bancshares, Inc.

We have reviewed the accompanying interim consolidated financial information of Merrill Merchants Bancshares, Inc. and Subsidiary as of September 30, 2006, and for the three- and nine-month periods ended September 30, 2006 and 2005. These financial statements are the responsibility of the Company’s management.

We conducted our reviews in accordance with standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures to financial data and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit in accordance with standards of the Public Company Accounting Oversight Board (United States), the objective of which is to express an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

Based on our reviews, we are not aware of any material modifications that should be made to the accompanying financial statements for them to be in conformity with U. S. generally accepted accounting principles.

/s/ BERRY, DUNN, McNEIL & PARKER

Bangor, Maine

November 1, 2006

3

MERRILL MERCHANTS BANCSHARES, INC. AND SUBSIDIARY

Consolidated Statements of Financial Condition

	September 30,			December 31,
	2006			2005
(In thousands, except number of shares)	(Unaudited)			(Audited)
ASSETS
Cash and due from banks	$	9,664		$	13,785
Federal funds sold		13,000			—
Interest-bearing deposits with banks		87			43
Total cash and cash equivalents		22,751			13,828
Investment securities - available for sale		79,098			72,489
Loans held for sale		859			925
Loans receivable		330,045			318,965
Less allowance for loan losses		4,214			4,086
Net loans receivable		325,831			314,879
Properties and equipment, net		5,414			4,863
Cash surrender value of life insurance		4,131			4,018
Deferred income tax benefit		1,495			1,372
Other real estate owned		17			—
Accrued income and other assets		5,356			4,699
Total assets	$	444,952		$	417,073
LIABILITIES AND SHAREHOLDERS’ EQUITY
Demand deposits	$	54,515		$	56,204
Savings and NOW deposits		152,282			151,798
Certificates of deposit		151,484			123,412
Total deposits		358,281			331,414
Securities sold under agreements to
repurchase (term and demand)		22,577			18,534
Other borrowed funds		21,774			28,474
Accrued expenses and other liabilities		5,091			4,299
Total liabilities		407,723			382,721
Shareholders’ equity
Common stock, par value $1; authorized 4,000,000 shares, issued and
outstanding 3,550,010 shares in 2006 and 3,435,633 shares in 2005		3,550			3,436
Capital surplus		26,634			24,188
Retained earnings		7,101			6,947
Accumulated other comprehensive loss
Unrealized loss on securities available for sale, net of tax		(56	)		(167	)
Net unrealized depreciation on derivative instruments marked to market,
net of tax		—			(52	)
Total shareholders’ equity		37,229			34,352
Total liabilities and shareholders’ equity	$	444,952		$	417,073

See report of independent registered public accounting firm. The accompanying notes are

an integral part of these consolidated financial statements

4

MERRILL MERCHANTS BANCSHARES, INC. AND SUBSIDIARY

Consolidated Statements of Income

(Unaudited)

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
(In thousands, except per share data)	2006		2005		2006		2005
Interest and dividend income
Interest and fees on loans	$	6,336	$	5,297	$	18,091	$	14,757
Interest on investment securities		840		532		2,332		1,543
Dividends on investment securities		57		42		138		107
Interest on federal funds sold		116		80		118		106
Total interest and dividend income		7,349		5,951		20,679		16,513
Interest expense
Interest on savings and NOW		897		590		2,414		1,388
Interest on certificates of deposit		1,621		979		4,253		2,663
Interest on borrowed funds		429		321		1,360		911
Total interest expense		2,947		1,890		8,027		4,962
Net interest income		4,402		4,061		12,652		11,551
Provision for loan losses		87		106		346		300
Net interest income after provision for
loan losses		4,315		3,955		12,306		11,251
Non-interest income
Service charges on deposit accounts		378		387		1,161		1,092
Other service charges and fees		230		210		665		616
Trust fees		445		392		1,328		1,171
Mortgage banking income		169		97		485		489
Net gain on investment securities		1		—		68		19
Other		113		116		344		393
Total non-interest income		1,336		1,202		4,051		3,780
Non-interest expense
Salaries and employee benefits		1,877		1,742		5,526		5,096
Occupancy expense		240		217		754		715
Equipment expense		164		154		502		474
Data processing		155		146		472		462
Other		733		691		2,279		2,114
Total non-interest expense		3,169		2,950		9,533		8,861
Income before income taxes		2,482		2,207		6,824		6,170
Income tax expense		835		745		2,311		2,086
Net income	$	1,647	$	1,462	$	4,513	$	4,084
Per share data
Basic earnings per common share	$	.46	$	.41	$	1.27	$	1.15
Diluted earnings per common share	$	.46	$	.41	$	1.26	$	1.14

See report of independent registered public accounting firm. The accompanying notes are

an integral part of these consolidated financial statements.

5

MERRILL MERCHANTS BANCSHARES, INC. AND SUBSIDIARY

Consolidated Statements of Changes in Shareholders’ Equity

For the Nine Months Ended September 30, 2006 and 2005

(Unaudited)

(In Thousands, Except Number of Shares and Per Share Data)

										Unrealized			Net
										Gain (Loss)			Unrealized
										On Securities			Depreciation			Total Share-
	Common			Capital			Retained			Available			on Derivative			holders’
	Stock			Surplus			Earnings			for Sale			Instruments			Equity
Balance at December 31, 2004	$	3,340		$	22,037		$	5,763		$	203		$	(14	)	$	31,329
Net income		—			—			4,084			—			—			4,084
Unrealized loss on
derivative instruments, net of
deferred taxes of ($25)		—			—			—			—			(48	)		(48	)
Change in unrealized gain on
securities available for sale, net
of deferred taxes of ($56)		—			—			—			(114	)		—			(114	)
Total comprehensive income		—			—			4,084			(114	)		(48	)		3,922
Common stock options exercised,
787 shares		1			8			—			—			—			9
Common stock repurchased (5,500
shares at $21.70)		(5	)		(114	)		—			—			—			(119	)
3% common stock dividend declared		100			2,251			(2,355	)		—			—			(4	)
Common stock cash dividend
declared, $0.47 per share		—			—			(1,615	)		—			—			(1,615	)
Balance at September 30, 2005	$	3,436		$	24,182		$	5,877		$	89		$	(62	)	$	33,522
Balance at December 31, 2005	$	3,436		$	24,188		$	6,947		$	(167	)	$	(52	)	$	34,352
Net income		—			—			4,513			—			—			4,513
Unrealized gain on
derivative instruments, net of
deferred taxes of $27		—			—			—			—			52			52
Change in unrealized loss on
securities available for sale, net
of deferred taxes of $58		—			—			—			111			—			111
Total comprehensive income		—			—			4,513			111			52			4,676
3% common stock dividend declared		103			2,370			(2,479	)		—			—			(6	)
Common stock options exercised,
14,887 shares		15			161			—			—			—			176
Common stock repurchased (3,757
shares at $23.58)		(4	)		(85	)		—			—			—			(89	)
Common stock cash dividend
declared, $0.53 per share		—			—			(1,880	)		—			—			(1,880	)
Balance at September 30, 2006	$	3,550		$	26,634		$	7,101		$	(56	)	$	—		$	37,229

See report of independent registered public accounting firm. The accompanying notes are

an integral part of these consolidated financial statements.

6

MERRILL MERCHANTS BANCSHARES, INC. AND SUBSIDIARY

Consolidated Statements of Cash Flows

For the Nine Months Ended September 30, 2006 and 2005

(Unaudited)

(In thousands)	2006			2005
Cash flows from operating activities
Net income	$	4,513		$	4,084
Adjustments to reconcile net income to net cash provided by operating activities
Depreciation		325			278
Amortization		374			238
Net amortization on investment securities		37			350
Deferred income taxes		(208	)		(158	)
Provision for loan losses		346			300
Net gain on sale of credit cards, investment securities and properties and equipment		(59	)		(365	)
Net change in:
Loans held for sale		66			(776	)
Deferred loan fees, net		(45	)		(78	)
Accrued income and other assets		(773	)		(449	)
Accrued expenses and other liabilities		792			559
Net cash provided by operating activities		5,368			3,983
Cash flows from investing activities
Net loans made to customers		(11,270	)		(28,081	)
Acquisition of properties and equipment and computer software		(899	)		(1,152	)
Purchase of investment in limited partnership		(276	)		—
Purchase of investment securities available for sale		(36,697	)		(45,243	)
Proceeds from sales and maturities of investment securities available for sale		30,286			40,672
Net cash used by investing activities		(18,856	)		(33,804	)
Cash flows from financing activities
Net (decrease) increase in demand, savings and NOW deposits		(1,205	)		13,821
Net increase in certificates of deposit		28,072			11,392
Net increase in securities sold under agreement to repurchase		4,043			3,619
Net (decrease) increase in other borrowed funds		(3,781	)		187
Long-term advances from the Federal Home Loan Bank		—			10,000
Payments on long-term advances		(2,919	)		(2,430	)
Dividends paid on common stock		(1,886	)		(1,571	)
Repurchase of common stock		(89	)		(119	)
Proceeds from stock issuance		176			9
Net cash provided by financing activities		22,411			34,908
Net increase in cash and cash equivalents		8,923			5,087
Cash and cash equivalents, beginning of period		13,828			10,220
Cash and cash equivalents, end of period	$	22,751		$	15,307
Supplemental disclosures of cash flow information
Cash paid for interest	$	7,702		$	5,028
Transfers to other real estate owned		17			—
Income tax paid		2,344			2,089

See report of independent registered public accounting firm. The accompanying notes are

an integral part of these consolidated financial statements.

7

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 - BASIS OF PRESENTATION

Merrill Merchants Bancshares, Inc. (the “Company”) is a financial holding company that owns all of the common stock of Merrill Merchants Bank (the “Bank”). The accompanying unaudited consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. All significant intercompany transactions and balances are eliminated in consolidation. The income reported for the period ended September 30, 2006 is not necessarily indicative of the results that may be expected for the year ending December 31, 2006. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2005.

NOTE 2 - EARNINGS PER SHARE

The following table sets forth the computation of basic and diluted earnings per share for the three and nine months ended September 30, 2006 and 2005:

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2006		2005		2006		2005
(In thousands, except for number of shares and per share data)
Net income, as reported	$	1,647	$	1,462	$	4,513	$	4,084
Weighted-average shares outstanding		3,548,600		3,538,180		3,546,356		3,540,915
Effect of dilutive stock options		24,195		30,773		23,714		29,979
Adjusted weighted-average shares outstanding		3,572,795		3,568,953		3,570,070		3,570,894
Basic earnings per share	$	.46	$	.41	$	1.27	$	1.15
Diluted earnings per share	$	.46	$	.41	$	1.26	$	1.14

The basic earnings per share computation is based upon the weighted-average number of shares of stock outstanding during the period. Potential common stock is considered in the calculation of weighted-average shares outstanding for diluted earnings per share.

The Company declared a 3% stock dividend in both 2006 and 2005. Earnings and cash dividends per share and weighted-average shares outstanding have been retroactively restated to reflect the stock dividends.

8

NOTE 3 - IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS

Statement of Financial Accounting Standards (“SFAS”) No. 156, Accounting for Servicing of Financial Assets-an Amendment to FASB Statement No. 140, requires all separately recognized servicing assets and servicing liabilities to be initially measured at fair value, if practicable. Servicing assets and servicing liabilities will subsequently be reported using the amortization method or the fair value measurement method. An entity should adopt SFAS No. 156 as of the beginning of its first fiscal year that begins after September 15, 2006 with earlier application permitted with certain restrictions. The initial application of the fair value measurement method would be reported as a cumulative effect adjustment to beginning retained earnings. SFAS No. 156 requires certain disclosures about the basis for measurement and regarding risks, activity, and fair value of servicing assets and of servicing liabilities. Management does not expect SFAS No. 156 to have a material impact on the Company’s financial statements.

The Financial Accounting Standards Board (“FASB”) has issued SFAS No. 123 (revised 2004) (SFAS No. 123(R)), Share-Based Payment. SFAS No. 123(R), with certain exceptions, requires entities that grant stock options and shares to employees to recognize the fair value of those options and shares as compensation cost over the service (vesting) period in their financial statements. The measurement of that cost is based on the fair value of the equity or liability instruments issued. The Securities and Exchange Commission (“SEC”) has issued Staff Accounting Bulletin (SAB) No. 107, which provides guidance regarding the interaction between SFAS No. 123(R) and certain SEC rules and regulations. The adoption of SFAS No. 123(R) did not have a material effect on the Company’s financial statements for the period ended September 30, 2006.

In July 2006, FASB issued Financial Accounting Standards Interpretation No. 48 (“FIN 48”), Accounting for Uncertainty in Income Taxes. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements in accordance with SFAS No. 109, Accounting for Income Taxes. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosures and transitions. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company does not expect FIN 48 to have a material effect on the financial condition and results of operations of the Company.

In September 2006, the SEC issued SAB No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements. SAB No. 108 requires registrants to evaluate the materiality of unadjusted financial statement misstatements using both the rollover and iron curtain methods. The rollover method quantifies a misstatement based on the amount of the error originating in the current period statement of income. The iron curtain method quantifies a misstatement based on the effects of correcting the misstatement existing in the statement of financial condition at the end of the current period, irrespective of the misstatement’s year(s) of origination. SAB No. 108 is effective for years ending after November 15, 2006. The cumulative effect of the initial application on prior years is required to be reported as an adjustment to retained earnings at the beginning of the year of initial application. Management is studying the effects of SAB No. 108 on the Company’s financial statements.

9

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FORWARD-LOOKING STATEMENTS

Certain disclosures in Management's Discussion and Analysis of Financial Condition and Results of Operations and elsewhere in this quarterly filing contain certain forward-looking statements. These forward-looking statements may be contained in this quarterly filing with the Securities and Exchange Commission (the “SEC”), the Annual Report to Shareholders, other filings with the SEC, and in other communications by Merrill Merchants Bancshares, Inc. (the “Company”) and its wholly-owned subsidiary, Merrill Merchants Bank (the “Bank”), which are made in good faith pursuant to the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. The words “may,” “could,” “should,” “would,” “believe,” “anticipate,” “estimate,” “expect,” “intend,” “plan” and similar expressions are intended to identify forward-looking statements. In preparing these disclosures, management must make assumptions, including, but not limited to, the level of future interest rates, prepayments on loans and investment securities, required levels of capital, needs for liquidity, and the adequacy of the allowance for loan losses. These forward-looking statements may be subject to significant known and unknown risks uncertainties, and other factors, including, but not limited to, those matters referred to in the preceding sentence.

Although we believe that the expectations reflected in such forward-looking statements are reasonable, actual results may differ materially from the results discussed in these forward-looking statements. You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. The Company undertakes no obligation to republish revised forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. You are also urged to carefully review and consider the various disclosures made by the Company which attempt to advise interested parties of the facts which affect the Company's business.

CRITICAL ACCOUNTING POLICIES

Management’s discussion and analysis of the Company’s financial condition is based on the consolidated financial statements included in this report, which financial statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of such financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. On an ongoing basis, management evaluates its estimates, including those related to the allowance for loan losses. Management bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets that are not readily apparent from other sources. Actual results could differ from the amount derived from management’s estimates and assumptions under different assumptions or conditions.

Allowance for Loan Losses. Management believes the allowance for loan losses is a critical accounting policy that requires the most significant estimates and assumptions used in the preparation of the consolidated financial statements. The allowance for loan losses is based on management’s evaluation of the level of the allowance required in relation to the estimated loss exposure in the loan portfolio. Management believes the allowance for loan losses is a significant estimate and therefore regularly evaluates it for adequacy by taking into consideration factors such as prior loan loss experience, the character and size of the loan portfolio, business and economic conditions and management’s estimation of probable losses. The use of different estimates or assumptions could produce different provisions for loan losses.

10

Mortgage Servicing Rights. Servicing assets are recognized as separate assets when servicing rights are acquired through sale of residential mortgage assets. Capitalized servicing rights are reported in other assets and are amortized into non-interest expense in proportion to, and over the period of, the estimated future net servicing income of the underlying financial residential mortgage assets. Servicing assets are evaluated for impairment based upon the fair value of the rights as compared to amortized costs. Fair value is determined based upon discounted cash flows using market-based assumptions. When the book value exceeds fair value, an impairment allowance is recognized so that mortgage servicing rights are carried at the lower of amortized book value or fair value. In periods of falling market interest rates, accelerated loan prepayment speeds can adversely impact the fair value of these mortgage servicing rights relative to their book value. In the event that the fair value of these assets were to increase in the future, the Company can recognize the increased fair value to the extent of the impairment allowance but cannot recognize an asset in excess of its amortized book value. Future changes in management’s assessment of the impairment of these servicing assets, as a result of changes in observable market data relating to market interest rates, loan prepayment speeds, and other factors, could impact the Company’s financial condition and results of operations either positively or adversely. On a quarterly basis, an independent third party determines the valuation of the Company’s mortgage servicing rights asset.

EXECUTIVE OVERVIEW

Net income increased 13% for the third quarter ended September 30, 2006 compared to the third quarter last year, an increase of $185,000. The following were significant factors related to the results to the third quarter of 2006 compared to the third quarter of 2005.

§Net interest income increased $341,000, or 8%, to $4.4 million. The increase was driven by $40.8 million of growth in average earning assets. The Company’s net interest margin decreased to 4.21% for the third quarter of 2006, compared to 4.29% for the same period in 2005, as the cost of funds increased by 95 basis points while the yield on earning assets increased 72 basis points.

§Non-interest income increased 11% to $1.3 million for the third quarter of 2006 compared to $1.2 million for the third quarter of 2005. The $134,000 increase in non-interest income was due to an increase in mortgage banking income of 74%, growth in trust fees of 14% and increases in other service charges and fees of 10%.

§Non-interest expense increased $219,000, or 7%, to $3.2 million for the third quarter of 2006 compared to the third quarter of 2005. The increase was the result of an increase in personnel costs of 8% and an increase in other expenses of 6%.

§Comparing September 30, 2006 and 2005, total loans grew $19.0 million or 6%. Loans to businesses increased 11% and consumer loans grew 26% from a year ago. Real estate loan activity has slowed compared to 2005; however, growth was steady with the commercial real estate portfolio increasing 4%, home equity balances growing 11% and residential mortgages up 4%. Construction balances decreased $4.0 million from a year ago.

§Total deposits were $358.3 million at September 30, 2006 compared to $325.0 million a year ago, representing growth of $33.3 million or 10%. Short-term interest rate increases and stock market volatility have spurred a migration of funds from core deposits as well as an influx of new funds to higher yielding certificates of deposit. Certificates of deposit grew $34.9 million or 30% from a year ago. Comparing September 30, 2006 and 2005, money market balances increased $3.0 million while savings account balances decreased $4.4 million and checking accounts declined $114,000.

11

RESULTS OF OPERATIONS

The Company reported net income of $4.5 million, or $1.26 per diluted share, for the first nine months of 2006. This is an increase of $429,000, or 11%, compared to net income of $4.1 million, or $1.14 per diluted share, for the comparable period of 2005. Net income for the third quarter of 2006 increased $185,000, or 13%, to $1.6 million compared with the third quarter of 2005 and earnings per diluted share increased to $0.46 compared to $0.41 for the same period.

The annualized return on assets and return on equity were 1.40% and 16.87%, respectively, for the first nine months of 2006 compared to return on assets of 1.42% and return on equity of 16.95% for the same period in 2005. For the third quarter of 2006, the annualized return on assets and return on equity were 1.48% and 17.89%, respectively compared to return on assets of 1.45% and return on equity of 17.60% for the same period in 2005.

NET INTEREST INCOME

Net interest income is interest earned on interest-earning assets less interest incurred on interest-bearing liabilities. Interest-earning assets are categorized as loans, investment securities and other earning assets, which include federal funds sold and interest-bearing deposits in other financial institutions. Interest-bearing liabilities are categorized as customer deposits, time and savings deposits and borrowings including repurchase agreements, short-term borrowings and long-term debt. Net interest income depends on the volume of average interest-earning assets and average interest-bearing liabilities and the interest rates earned or incurred on them.

Net interest income totaled $12.7 million for the first nine months of 2006, an increase of $1.1 million compared to the same period in 2005. The 10% increase was driven by growth in average earning assets of $44.4 million. The Company’s net interest margin decreased to 4.12% for the first nine months of 2006 compared to 4.22% for the same period last year.

Since June 2004, the Board of Governors of the Federal Reserve System has steadily increased the Federal Funds targeted rate from 1.00% to 5.25% at September 30, 2006. The decline in the Company’s net interest margin is the result of the interest rate incurred on interest-bearing liabilities increasing at a faster pace than the yield on interest-earning assets. The Company has experienced a shift in its deposit mix from core deposits to higher yielding certificates of deposit.

The average rate earned on interest-earning assets increased to 6.75% from 6.04% for the nine months ended September 30, 2006 and 2005, respectively, on average interest-earning assets of $408.7 million and $364.3 million for the corresponding periods. The average interest rate incurred on interest-bearing liabilities also increased, to 3.17% from 2.24% for the nine months ended September 30, 2006 and 2005, respectively, on average interest-bearing liabilities of $338.3 million and $295.6 million for the corresponding periods.

Net interest income totaled $4.4 million for the third quarter of 2006, an increase of $341,000, or 8%, over the same period in 2005. The net interest margin decreased to 4.21% for the third quarter of 2006 as compared to 4.29% for the same period in 2005. The yield on average earning assets for the third quarter of 2006 and 2005 was 6.98% and 6.26%, respectively, and the average interest rate incurred on interest-bearing liabilities was 3.39% and 2.44%, respectively.

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PROVISION FOR LOAN LOSSES

The provision for loan losses was $346,000 for the nine months ended September 30, 2006 compared to $300,000 for the same period in 2005. The increase in the provision for loan losses was appropriate given the continued growth of the loan portfolio and the overall credit quality of the portfolio.

In originating loans, the Company recognizes that it will experience loan losses and that the risk of loss will vary with, among other things, the type of loan being made, the creditworthiness of the borrower over the term of the loan and, in the case of collateralized loans, the quality of the collateral for the loan as well as general economic conditions. It is management's policy to attempt to maintain an appropriate allowance for loan losses based on, among other things, industry standards, management's experience, the Bank's historical loan loss experience, evaluation of economic conditions and regular reviews of delinquencies and loan portfolio quality.

Provisions result from management’s continuing review of the loan portfolio as well as its judgment as to the adequacy of the reserves in light of the condition of the economy and the real estate market. Management believes that based on information currently available, the allowance for loan losses is appropriate and overall credit quality remains strong.

Management continues to actively monitor the Company's asset quality and to charge off loans against the allowance for loan losses when appropriate or to provide specific loan allowances when necessary. Although management believes it uses the best information available to make determinations with respect to the allowance for loan losses, future adjustments may be necessary if economic conditions differ from the economic conditions in the assumptions used in making the final determinations. The Company’s allowance for loan losses amounted to $---4.2 million at September 30, 2006, or 1.28% of total loans, an increase of $128,000 since December 31, 2005.

NON-INTEREST INCOME

Non-interest income was $4.1 million for the nine months ended September 30, 2006, an increase of $271,000 compared to the same period in 2005. The 7% increase in non-interest income was due to an increase in trust fees of $157,000, increases in service charges on deposit accounts of $69,000 and an increase in investment security gains of $49,000.

Non-interest income was $1.3 million for the third quarter of 2006, an increase of 11% from the same period in 2005. The $134,000 increase in non-interest income was due to an increase in mortgage banking income of 74%, growth in trust fees of 14% and increases in other service charges and fees of 10%.

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NON-INTEREST EXPENSE

Non-interest expense totaled $9.5 million for the nine months ended September 30, 2006 compared to $8.9 million for the same period last year. The increase in non-interest expense of $672,000, or 8%, was due to an increase in personnel costs of 8%, increases in occupancy, equipment and data processing expenses of 5% and an increase in other expenses of 8%. Personnel costs increased $430,000 due to normal salary increases and additional staffing required as a result of asset growth, and other expenses increased $165,000 due to increases in professional fees, postage costs and ATM/debit card processing expense.

Non-interest expense totaled $3.2 million for the third quarter of 2006 compared to $3.0 million for the same period last year. The increase in non-interest expense of $219,000, or 7%, was due to increases in personnel costs of $135,000 and general increases in all other expense categories.

The Company’s efficiency ratio improved to 57.3% for the first nine months of 2006 compared to 58.3% for the same period in 2005 and was 55.2% and 56.1% for the third quarters ended September 30, 2006 and 2005, respectively.

FINANCIAL CONDITION

Total assets increased $27.9 million, or 7%, to $445.0 million during the first nine months of 2006. Since December 31, 2005, the loan portfolio increased $11.0 million or 4%. Consumer loans increased 20%, home equity balances were up 11%, residential balances grew 4% and the commercial and commercial real estate portfolio grew 2%. Construction loan balances decreased 23%. The investment portfolio increased $6.6 million, or 9%, since year-end and cash and cash equivalents increased $8.9 million. Asset growth was funded by certificates of deposit.

Total deposits increased $26.9 million, or 8%, to $358.3 million for the first nine months of 2006. Short-term interest rate increases and stock market volatility have spurred a migration of funds from core deposits as well as an influx of new funds to higher yielding certificates of deposit. Since December 31, 2005, certificates of deposit grew $28.1 million, or 23%, money market balances increased $4.4 million, checking accounts increased $335,000 and savings accounts declined by $6.0 million. Borrowed funds decreased by $2.7 million to $44.4 million at September 30, 2006 primarily due to a decrease in short-term borrowings.

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LIQUIDITY AND CAPITAL RESOURCES

Liquidity represents the ability to meet both asset growth and deposit withdrawals. Many factors affect a company’s ability to meet liquidity needs, including changes in the markets served, its asset-liability mix, its reputation and credit standing in the market and general economic conditions. In addition to traditional in-market deposit sources, the Company has other sources of liquidity, including proceeds from maturing investment securities and loans, the sale of investment securities, federal funds through correspondent bank relationships, brokered deposits and Federal Home Loan Bank borrowings. Additional liquidity is available in the loan portfolio through sale of residential mortgages and the guaranteed portion of Small Business Administration loans. Management believes that the current level of liquidity is sufficient to meet current and future funding requirements.

The Company’s total shareholders’ equity was $37.2 million, or 8.4%, of total assets at September 30, 2006 compared to $34.4 million, or 8.2%, of total assets at December 31, 2005.  The net increase of $2.9 million in the first nine months of 2006 was attributable to net income of $4.5 million, changes in unrealized losses on investment securities and derivative instruments of $163,000, net of tax and stock option exercises of $176,000 less cash dividends of $1.9 million. In the third quarter of 2006, the Company declared a cash dividend of $.18 per share on the Company’s common stock. This was an increase of 16% over last year’s third quarter dividend.

Under Federal Reserve Board guidelines, bank holding companies such as the Company are required to maintain capital based on “risk-adjusted” assets. These guidelines apply to the Company on a consolidated basis. Under the current guidelines, banking organizations must maintain a risk-based capital ratio of 8%. The Company’s risk-based capital ratios for Tier 1 and Tier 2 capital at September 30, 2006, of 11.30% and 12.65%, respectively, exceed regulatory guidelines for a “well capitalized” financial institution. The Company’s ratios at December 31, 2005 were 11.06% and 12.40%, respectively.

On June 17, 2004, the Board of Directors approved a fourth stock repurchase program authorizing the Company to repurchase up to 169,995, or 5%, of its outstanding shares of common stock. As of September 30, 2006, 25,894 shares had been repurchased under the program. During the third quarter of 2006, the Company repurchased 3,757 shares at an average price of $23.58 per share. The repurchases will be made from time to time at the discretion of Company management.

OFF-BALANCE-SHEET ITEMS

The Bank is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers which involve, to varying degrees, elements of credit risk in excess of the amount recognized in the consolidated statements of financial condition. The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit is represented by the contractual notional amount of those instruments. The Bank follows the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments, including requiring collateral or other security to support financial instruments with credit risk. At September 30, 2006, the Company had the following levels of commitments to extend credit:

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			Commitment expires in:
(In thousands)	Total amount committed		Less than 1 year		1 - 3 years		4 - 5 years		After 5 years
Letters of credit	$	1,136	$	732	$	254	$	150	$	—
Other commitments to extend credit		85,946		41,990		12,339		1,254		30,363
Total	$	87,082	$	42,722	$	12,593	$	1,404	$	30,363

The Company is a party to several off-balance sheet contractual obligations through lease agreements on branch facilities. These commitments, borrowings and the related payments were made during the normal course of business. At September 30, 2006, the Company had the following levels of contractual obligations:

			Payments due by period:
(In thousands)	Total amount of obligation		Less than 1 year		1 - 3 years		4 - 5 years		After 5 years
Operating leases	$	2,029	$	300	$	447	$	176	$	1,106
Federal Home Loan Bank debt		20,015		4,808		7,255		6,649		1,303
Total	$	22,044	$	5,108	$	7,702	$	6,825	$	2,409

ITEM 3.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Market risk is the risk of loss in a financial instrument arising from adverse changes in market rates/prices, such as interest rates, foreign currency exchange rates, commodity prices and equity prices. The Company’s primary market risk exposure is interest rate risk. The ongoing monitoring and management of this risk is an important component of the Company’s asset/liability management process, which is governed by policies established by the Board of Directors that are reviewed and approved annually. The Board of Directors delegates responsibility for carrying out the asset/liability management policies to its Asset/Liability Committee (“ALCO”). In this capacity, ALCO develops guidelines and strategies impacting the Company’s asset/liability management activities based upon estimated market risk sensitivity, policy limits and overall market interest rate levels/trends.

Interest rate risk represents the sensitivity of earnings to changes in market interest rates. As interest rates change, the interest income and expense streams associated with the Company’s financial instruments also change, thereby impacting net interest income (“NII”), the primary component of the Company’s earnings. ALCO utilizes the results of a detailed and dynamic simulation model to quantify the estimated exposure of NII to sustained interest rate changes. While ALCO routinely monitors simulated NII sensitivity over a rolling two-year horizon, it also utilizes additional tools to monitor potential longer-term interest rate risk.

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The simulation model captures the impact of changing interest rates on the interest income earned and interest expense incurred on all interest-earning assets and interest-bearing liabilities reflected in the Company’s statement of financial condition. This sensitivity analysis is compared to ALCO policy limits which specify a maximum tolerance level for NII exposure over a one-year horizon, assuming no asset growth, given a 200 basis point (bp) upward and a 200 bp downward shift in interest rates. A parallel and pro rata shift in rates over a 12-month period is assumed. The following reflects the Company’s NII sensitivity analysis as measured during the third quarter of 2006.

	Estimated
Rate Change	Change in NII
+200bp		0.53	%
-200bp		(2.76	)%

The preceding sensitivity analysis does not represent a Company forecast and should not be relied upon as being indicative of expected operating results. These hypothetical estimates are based upon numerous assumptions including, among others, the nature and timing of interest rate levels, yield curve shape, prepayments on loans and securities, deposit decay 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, the Company cannot make any assurances as to the predictive nature of these assumptions, including how customer preferences or competitor influences might change.

ITEM 4. CONTROLS AND PROCEDURES

Management, including the Company’s Chairman, Chief Executive Officer and Principal Executive Officer and Executive Vice President, Treasurer and Principal Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this report. Based upon that evaluation, the Chairman and Chief Executive Officer and Executive Vice President and Treasurer concluded that the disclosure controls and procedures were effective to ensure that information required to be disclosed in the reports the Company files and submits under the Exchange Act is (i) recorded, processed, summarized and reported as and when required and (ii) accumulated and communicated to the Company’s Principal Executive Officer and Principal Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

There have been no changes in the Company’s internal control over financial reporting identified in connection with the evaluation that occurred during the Company’s last fiscal quarter that have materially affected, or that are reasonably likely to materially affect, the Company’s internal control over financial reporting.

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PART II. OTHER INFORMATION

Item 1LEGAL PROCEEDINGS

None

Item 1ARISK FACTORS

There have been no material changes to the risk factors included in the Company’s Annual Report of Form 10-K for the year ended December 31, 2005 that could affect our business results of operations or financial condition.

Item 2UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

During the three months ended September 30, 2005, the Company repurchased the following shares of the common stock:

Period	(a) Total Number of Shares Purchased		(b) Average Price Paid per Share		(c) Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs		(d) Maximum Number of Shares that May Yet Be Purchased Under the Plans or Programs
July 1 - 31, 2006		—		—		—		147,858
August 1 - 31, 2006		3,757	$	23.58		3,757		144,101
September 1-30, 2006		—		—		—		144,101

On June 17, 2004, the Board of Directors approved a fourth stock repurchase program authorizing the Company to repurchase up to 169,995 shares of the Company’s common stock. At September 30, 2006, the maximum number of shares that may yet be purchased under the program is 144,101. The authority may be exercised from time to time and in such amounts as market conditions warrant. Shares are being repurchased for other corporate purposes. The program does not have an expiration date.

Item 3DEFAULTS UPON SENIOR SECURITIES

None

Item 4SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None

Item 5OTHER INFORMATION

None

Item 6EXHIBITS

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Exhibit	Description
3.1	Articles of Incorporation of Merrill Merchants Bancshares, Inc. (1)
3.2	By-laws of Merrill Merchants Bancshares, Inc. (1)
4	Specimen Stock Certificate of Merrill Merchants Bancshares, Inc. (1)
10.1	Operating Agreement between the Company and M&M Consulting Limited Liability Company. (1)
10.2	Services Agreements between the Company and M&M Consulting Limited Liability Company. (1)
10.3	Amended and Restated Employment Agreement with William C. Bullock, Jr. (2)
10.4	Financial Services Agreement with Financial Institutions Service Corporation. (1)
10.5	Form of Life Insurance Endorsement Method Split Dollar Plan Agreement. (1)
10.6	Not used.
10.7	Form of Amended and Restated Executive Supplemental Retirement Plan. (3)
10.8	Form of Mandatory Convertible Debentures. (1)
10.9	Correspondent Trust Services Agreement with Northern Trust Company. (1)
10.10	Stock Option Plan, as amended. (1)
10.11	Form of Stock Option Agreement. (1)
10.12	Not used.
10.13	Employment Agreement between the Company and Edwin N. Clift. (4)
10.14	Employment Agreement between the Company and William P. Lucy. (4)
10.15	Employment Agreement between the Company and Deborah A. Jordan. (4)
10.16	2005 Directors’ Deferred Compensation Plan. (5)
31	Rule 13a - 14(a)/15d - 14(a) Certifications.
32	Section 1350 Certifications.

(1) Incorporated by reference to the Company’s Registration Statement on Form SB-2, File No. 333-56197, as amended.

(2) Incorporated by reference to the Company’s Form 10-Q for the quarter ended September 30, 2004.

(3) Incorporated by reference to the Company’s Form 10-K for the year ended December 31, 2005.

(4) Incorporated by reference to the Company’s Form 10-KSB for the year ended December 31, 2003.

(5) Incorporated by reference to the Company’s Form 10-Q for the quarter ended September 30, 2005.

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SIGNATURES

In accordance with 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.

	MERRILL MERCHANTS BANCSHARES, INC.
Date: November 14, 2006	By:	/s/ Edwin N. Clift
		Edwin N. Clift
		Chairman and Chief Executive Officer (Principal Executive Officer)

Date: November 14, 2006	By:	/s/ Deborah A. Jordan
		Deborah A. Jordan
		Executive Vice President and Treasurer (Principal Financial and Accounting Officer)

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