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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998
COMMISSION FILE NUMBER 0-11595
MERCHANTS BANCSHARES, INC.
(Exact name of registrant as specified in its charter)
Incorporated in the State of Delaware Employer Identification No. 03-0287342
164 College St., Burlington, Vermont 05401
(Address of principal executive office) (Zip Code)
Registrant's telephone number: (802) 658-3400
Securities registered pursuant to Section 12(b) of the Act:
(Not Applicable)
Securities registered pursuant to Section 12(g) of the Act:
Title of Class: Common Stock (Par Value $.01 a share)
Name of Exchange on which listed: NASDAQ
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.
Yes X No
----- -----
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K.
X Contained herein Not contained herein
----- -----
The aggregate market value of the voting stock held by non-affiliates is
$104,750,428 as computed using the average bid and asked prices of stock, as
of February 23, 1999.
The number of shares outstanding for each of the registrant's classes of
common stock, as of February 23, 1999 is:
Class: Common stock, par value $.01 per share
Outstanding: 4,375,997 shares
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Annual Report to Shareholders for the year ended December
31, 1998 are incorporated herein by reference to Parts I and II.
Portions of the Proxy Statement to Shareholders for the year ended December
31, 1998 are incorporated herein by reference to Part III.
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TABLE OF CONTENTS Page
Independent Auditors' Report 3
Consolidated Balance Sheets 4
Consolidated Statements of Operations 5
Consolidated Statements of Comprehensive Income 6
Consolidated Statements of Changes in Stockholders' Equity 7
Consolidated Statements of Cash Flows 8
Notes to Consolidated Financial Statements 9
Summary of Unaudited Quarterly Financial Information 30
Management's Discussion and Analysis of Financial Condition and
Results of Operations 33
Form 10-K 50
Five Year Selected Financial Data 60
Signatures 64
ARTHUR ANDERSEN LLP [LETTERHEAD]
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
TO THE STOCKHOLDERS AND BOARD OF DIRECTORS OF
MERCHANTS BANCSHARES, INC.
We have audited the accompanying consolidated balance sheets of Merchants
Bancshares, Inc. (a Delaware corporation) and subsidiaries as of December
31, 1998 and 1997, and the related consolidated statements of operations,
comprehensive income, changes in stockholders' equity and cash flows for
each of the three years in the period ended December 31, 1998. These
consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these
consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements.
An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of
Merchants Bancshares, Inc. and subsidiaries as of December 31, 1998 and
1997, and the results of its operations and its cash flows for each of the
three years in the period ended December 31, 1998, in conformity with
generally accepted accounting principles.
/s/ Arthur Andersen LLP
Boston, Massachusetts
January 15, 1999
Merchants Bancshares, Inc.
Consolidated Balance Sheets
December 31, December 31,
(In thousands except share and per share data) 1998 1997
- --------------------------------------------------------------------------------------------------------
ASSETS
Cash and Due from Banks $ 30,528 $ 20,139
Investments:
Debt Securities Available for Sale 72,205 44,241
Debt Securities Held to Maturity 103,851 111,458
(Fair Value of $105,717 and $112,467)
Trading Securities 1,095 1,031
- --------------------------------------------------------------------------------------------------------
Total Investments 177,151 156,730
- --------------------------------------------------------------------------------------------------------
Loans 405,492 390,388
Reserve for possible loan losses 11,300 15,831
- --------------------------------------------------------------------------------------------------------
Net Loans 394,192 374,557
- --------------------------------------------------------------------------------------------------------
Federal Home Loan Bank Stock 2,482 2,296
Bank Premises and Equipment, Net 13,185 13,428
Investments in Real Estate Limited Partnerships 2,860 1,972
Other Real Estate Owned 470 591
Other Assets 14,005 14,539
- --------------------------------------------------------------------------------------------------------
Total Assets $634,873 $584,252
========================================================================================================
LIABILITIES
Deposits:
Demand $ 85,998 $ 76,712
Savings, NOW and Money Market Accounts 309,897 267,396
Time Deposits $100 thousand and Greater 22,746 23,307
Other Time 131,821 138,429
- --------------------------------------------------------------------------------------------------------
Total Deposits 550,462 505,844
- --------------------------------------------------------------------------------------------------------
Demand Note Due U.S. Treasury 283 4,000
Other Short-Term Borrowings 9,000 4,000
Other Liabilities 7,890 11,057
Long-Term Debt 6,409 6,415
- --------------------------------------------------------------------------------------------------------
Total Liabilities 574,044 531,316
- --------------------------------------------------------------------------------------------------------
Commitments and Contingencies (Note 12)
STOCKHOLDERS' EQUITY
Preferred Stock Class A Non-Voting Authorized-200,000, Outstanding 0 - -
Preferred Stock Class B Voting Authorized-1,500,000, Outstanding 0 - -
Common Stock, $.01 Par Value 44 44
Shares Authorized 7,500,000
Outstanding, Current Period 4,259,278
Prior Period 4,290,698
Treasury Shares (At Cost) (3,133) (2,220)
Current Period 175,342
Prior Period 143,922
Capital in Excess of Par Value 33,073 33,223
Retained Earnings 28,308 21,537
Deferred Compensation Arrangements 2,166 (10)
Unrealized Gain on Securities Available for Sale, Net 371 362
- --------------------------------------------------------------------------------------------------------
Total Stockholders' Equity 60,829 52,936
- --------------------------------------------------------------------------------------------------------
Total Liabilities and Stockholders' Equity $634,873 $584,252
========================================================================================================
The accompanying notes are an integral part of these consolidated
financial statements.
Merchants Bancshares, Inc.
Consolidated Statements of Operations
Years Ended December 31,
(In thousands except per share data) 1998 1997 1996
- ------------------------------------------------------------------------------------------------
INTEREST AND DIVIDEND INCOME:
Interest and Fees on Loans $36,796 $38,543 $39,953
Interest and Dividends on Investments:
U.S. Treasury and Agency Obligations 10,728 9,433 7,588
Other 499 182 463
- ------------------------------------------------------------------------------------------------
Total Interest and Dividend Income 48,023 48,158 48,004
- ------------------------------------------------------------------------------------------------
INTEREST EXPENSE:
Savings, NOW and Money Market Accounts 9,175 8,403 8,216
Time Deposits $100 Thousand and Greater 1,566 1,428 1,397
Other Time Deposits 7,007 7,485 8,112
Other Borrowed Funds 322 509 345
Debt 460 413 602
- ------------------------------------------------------------------------------------------------
Total Interest Expense 18,530 18,238 18,672
- ------------------------------------------------------------------------------------------------
Net Interest Income 29,493 29,920 29,332
Provision for Possible Loan Losses (1,737) (1,862) 3,150
- ------------------------------------------------------------------------------------------------
Net Interest Income after Provision for Possible Loan Losses 31,230 31,782 26,182
- ------------------------------------------------------------------------------------------------
NONINTEREST INCOME:
Trust Company Income 1,910 1,635 1,493
Service Charges on Deposits 2,756 3,075 3,347
Merchant Discount Fees 1,444 1,537 1,696
Gains on Sale of Investment Securities, Net 44 784 33
FDIC Assistance Received-Loss Sharing - - 407
Other 1,158 885 2,387
- ------------------------------------------------------------------------------------------------
Total Noninterest Income 7,312 7,916 9,363
- ------------------------------------------------------------------------------------------------
NONINTEREST EXPENSES:
Salaries and Wages 9,434 8,682 8,222
Employee Benefits 2,036 1,992 1,791
Occupancy Expense, Net 1,974 2,171 2,054
Equipment Expense 2,593 2,325 2,024
Legal and Professional Fees 2,447 3,888 1,961
Provision for Impairment of Investment Security - 229 -
Equity in Losses of Real Estate Limited Partnerships 379 641 846
Losses on and Write-downs of Other Real Estate Owned 225 314 3,400
Losses and Write-downs of Segregated Assets - - 407
Loss (Gain) on Disposition of Fixed Assets 127 1,088 (565)
Other 6,257 7,152 7,349
- ------------------------------------------------------------------------------------------------
Total Noninterest Expenses 25,472 28,482 27,489
- ------------------------------------------------------------------------------------------------
Income Before Provision for Income Taxes 13,070 11,216 8,056
Provision for Income Taxes 3,248 2,383 1,832
- ------------------------------------------------------------------------------------------------
NET INCOME $ 9,822 $ 8,833 $ 6,224
================================================================================================
BASIC EARNINGS PER COMMON SHARE $ 2.22 $ 2.00 $ 1.45
DILUTED EARNINGS PER COMMON SHARE 2.21 1.99 1.45
The accompanying notes are an integral part of these consolidated
financial statements.
Merchants Bancshares, Inc.
Consolidated Statements of Comprehensive Income
Twelve Months Ended
December 31,
(In thousands) 1998 1997 1996
- -------------------------------------------------------------------------------------------------
Net Income as Reported $9,822 $8,833 $6,224
Change in Net Unrealized Appreciation of Securities, Net of Tax 40 625 (337)
Less: Reclassification Adjustments for Securities Gains Included
in Net Income, Net of Taxes 29 517 22
- -------------------------------------------------------------------------------------------------
Comprehensive Income before transfers from Available
for Sale to Held to Maturity 9,833 8,941 5,865
Impact of transfer from Available for Sale to Held to Maturity (2) 10 136
- -------------------------------------------------------------------------------------------------
Comprehensive Income $9,831 $8,951 $6,001
=================================================================================================
The accompanying notes are an integral part of these consolidated
financial statements.
Merchants Bancshares, Inc.
Consolidated Statements of Changes in Stockholders' Equity
For Each of the Three Years in the Period Ended December 31, 1998
Net Unrealized
Appreciation
Capital in Deferred (Depreciation)
Common Excess of Retained Treasury Compensation of Investment
(In thousands) Stock Par Value Earnings Stock Arrangements Securities Total
- -------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1995 $44 $33,155 $ 8,621 $ 2,038 - $ 467 $40,249
Net Income - - 6,224 - - - 6,224
Change in Net Unrealized
Appreciation (Depreciation) of
Securities Available for Sale,
Net of Tax - - - - - (359) (359)
Change in Net Unrealized
Appreciation of Securities
Transferred to the Held to
Maturity Portfolio, Net of Tax - - - - - 136 136
- -------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1996 44 33,155 14,845 (2,038) - 244 46,250
Net Income - - 8,833 - - - 8,833
Purchase of Treasury Stock - - - (1,390) - - (1,390)
Sales of Treasury Stock - 219 - 1,015 - - 1,234
Issuance of Stock under
Employee Stock Option Plans - (151) - 193 - - 42
Dividends Paid - - (2,141) - - - (2,141)
Unearned Compensation-
Restricted Stock Awards - - - - (10) - (10)
Change in Net Unrealized
Appreciation (Depreciation) of
Securities Available for Sale,
Net of Tax - - - - - 108 108
Change in Net Unrealized
Appreciation of Securities
Transferred to the Held to
Maturity Portfolio, Net of Tax - - - - - 10 10
- -------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1997 44 33,223 21,537 (2,220) (10) 362 52,936
Net Income - - 9,822 - - - 9,822
Purchase of Treasury Stock - - - (1,420) - - (1,420)
Issuance of Stock under
Employee Stock Option Plans - (210) - 374 - - 164
Tax Benefit Related to Stock
Option Exercises - 60 - - - - 60
Issuance of Stock under Deferred
Compensation Arrangements - - - 133 - - 133
Dividends Paid - - (3,051) - - - (3,051)
Unearned Compensation-
Restricted Stock Awards - - - - (20) - (20)
Compensation Arrangements - - - - 2,196 - 2,196
Change in Net Unrealized
Appreciation (Depreciation) of
Securities Available for Sale,
Net of Tax - - - - - 11 11
Change in Net Unrealized
Appreciation of Securities
Transferred to the Held to
Maturity Portfolio, Net of Tax - - - - - (2) (2)
- -------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1998 $44 $33,073 $28,308 $(3,133) $2,166 $ 371 $60,829
=========================================================================================================================
The accompanying notes are an integral part of these consolidated
financial statements.
Merchants Bancshares, Inc.
Consolidated Statement of Cash Flows
(In thousands) 1998 1997 1996
- ---------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net Income $ 9,822 $ 8,833 $ 6,224
Adjustments to Reconcile Net Income to Net Cash Provided by
Operating Activities:
Provision for Possible Loan Losses (1,737) (1,862) 3,150
Provision for Possible Losses on Other Real Estate Owned 20 34 2,495
Provision for Impairment of Investment Security - 229 -
Provision for Depreciation and Amortization 2,632 2,377 2,667
Net Gains on Sales of Investment Securities (44) (784) (33)
Net Gains on Sales of Loans and Leases (213) (11) (505)
Net Losses on Sales of Premises and Equipment 127 1,088 (565)
Net Gains (Losses) on Sales of Other Real Estate Owned 101 (138) (328)
Equity in Losses of Real Estate Limited Partnerships 379 641 846
Changes in Assets and Liabilities:
(Increase) Decrease in Interest Receivable (165) (63) 936
Increase (Decrease) in Interest Payable 33 14 (313)
(Increase) Decrease in Other Assets 698 (444) 5,527
Decrease in Other Liabilities (1,004) (44) (724)
- -------------------------------------------------------------------------------------------------------------------------
Net Cash Provided by Operating Activities 10,649 9,870 19,377
- -------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from Sales of Investment Securities Available for Sale 14,053 18,907 42,522
Proceeds from Maturities of Investment Securities 33,834 13,985 16,000
Proceeds from Sales of Loans and Leases 14,659 3,131 19,576
Purchases (Redemptions) of Federal Home Loan Bank Stock (186) 545 334
Proceeds from Sales of Premises and Equipment - 6 1,818
Proceeds from Sales of Other Real Estate Owned 1,179 2,112 6,144
Purchases of Available for Sale Investment Securities (58,156) (10,005) (105,929)
Purchases of Held to Maturity Investment Securities (10,272) (33,278) -
Loan Originations (in Excess of) Less than Principal Payments (32,990) (4,364) 37,292
Investments in Real Estate Limited Partnerships (1,362) (102) (111)
Purchases of Premises and Equipment (2,607) (4,099) (4,688)
- -------------------------------------------------------------------------------------------------------------------------
Net Cash Provided by (Used in) Investing Activities (41,848) (13,162) 12,958
- -------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net Increase (Decrease) in Deposits 44,618 (2,436) (36,234)
Net Increase (Decrease) in Other Borrowed Funds 1,283 (1,599) 4,263
Principal Payments on Debt (6) (5) (9,005)
Cash Dividends Paid (3,051) (2,141) -
Acquisition of Treasury Stock (1,420) (1,390) -
Proceeds From Sales of Treasury Stock - 1,234 -
Proceeds From Exercise of Employee Stock Options 164 42 -
- -------------------------------------------------------------------------------------------------------------------------
Net Cash Provided by (Used In) Financing Activities 41,588 (6,295) (40,976)
- -------------------------------------------------------------------------------------------------------------------------
Increase (Decrease) in Cash and Cash Equivalents 10,389 (9,587) (8,641)
Cash and Cash Equivalents Beginning of Year 20,139 29,726 38,367
- -------------------------------------------------------------------------------------------------------------------------
Cash and Cash Equivalents End of Period $ 30,528 $ 20,139 $ 29,726
=========================================================================================================================
Total Interest Payments $ 18,498 $ 18,224 $ 18,985
Total Income Tax Payments 2,170 3,820 -
Transfer of Loans and Premises to Other Real Estate Owned 954 515 2,815
Transfer of Securities Available for Sale to Held to Maturity Portfolio - - 87,509
The accompanying notes are an integral part of these consolidated
financial statements.
Merchants Bancshares, Inc.
Notes to Consolidated Financial Statements
December 31, 1998
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of
Merchants Bancshares, Inc. (the "Company") and its wholly owned
subsidiaries; Merchants Bank (the "Bank") including the Bank's wholly owned
subsidiaries Merchants Trust Company (the "Trust Company"), and certain
trusts; and Merchants Properties, Inc., after elimination of all material
intercompany accounts and transactions. Queneska Capital Corporation,
formerly a wholly owned subsidiary of the Bank, was dissolved in December
1997. The Bank and the Trust Company offer a full range of deposit, loan,
cash management and trust services to meet the financial needs of individual
consumers, businesses and municipalities at 33 full-service banking
locations throughout the State of Vermont.
Use of Estimates in Preparation of Financial Statements
The preparation of financial statements in conformity with generally
accepted accounting principles 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. Operating results in the future could vary from the
amounts derived from management's estimates and assumptions.
Investment Securities
The Company classifies certain of its investments in debt securities as held
to maturity, which are carried at amortized cost if the Company has the
positive intent and ability to hold such securities to maturity. Investments
in debt securities that are not classified as held to maturity and equity
securities that have readily determinable fair values are classified as
trading securities or available for sale securities. Trading securities are
investments purchased and held principally for the purpose of selling in the
near term; available for sale securities are investments not classified as
trading or held to maturity. Available for sale securities are carried at
fair value which is measured at each reporting date. The resulting
unrealized gain or loss is reflected in Comprehensive Income and
Stockholders' Equity net of the associated tax effect. Trading securities
are also carried at fair value, gains and losses are recognized through the
Statement of Operations.
Transfers from securities available for sale to securities held to maturity
are recorded at the securities' fair values on the date of the transfer. Any
net unrealized gains or losses continue to be reported as a separate
component of stockholders' equity, on a net of tax basis as long as the
securities are carried in the held to maturity portfolio, such amounts are
amortized over the estimated remaining life of the transferred securities as
an adjustment to yield in a manner consistent with the amortization of
premiums and discounts.
Dividend and interest income, including amortization of premiums and
discounts, is recorded in earnings for all categories of investment
securities. Discounts and premiums related to debt securities are amortized
using a method which approximates the level-yield method. The gain or loss
recognized on the sale of an investment security is based upon the adjusted
cost of the specific security.
Management reviews all reductions in fair value below book value to
determine whether the impairment is other than temporary. If the impairment
is determined to be other than temporary in nature, the carrying value of
the security is written down to the appropriate level by a charge to
earnings in the period of determination.
Loan Origination and Commitment Fees
Loan origination and commitment fees and certain direct loan origination
costs are deferred and amortized over the lives of the related loans. Net
deferred origination fees were $787 thousand and $859 thousand at December
31, 1998 and 1997, respectively.
Premises and Equipment
Premises and equipment are stated at cost, less accumulated depreciation and
amortization. Depreciation and amortization are provided using straight-line
and accelerated methods at rates that depreciate the original cost of the
premises and equipment over their estimated useful lives. Expenditures for
maintenance, repairs and renewals of minor items are generally charged to
expense as incurred. When premises and equipment are replaced, retired, or
deemed no longer useful they are valued at estimated selling price less
costs to sell, and to the extent the net book value exceeds this value the
difference is charged to current earnings.
Gains and Losses on Sales of Loans
Gains and losses on sales of loans are recognized based upon the difference
between the selling price and the carrying amount of loans sold. Gains and
losses are adjusted for excess servicing rights resulting from the sale of
certain loans with servicing rights retained. Origination fees collected,
net of commitment fees paid in connection with the sales of loans and net of
the direct cost of originating the loans, are recognized at the time such
loans are sold.
Income Taxes
Deferred tax assets and liabilities are reflected at currently enacted
income tax rates applicable to the period in which the deferred tax assets
or liabilities are expected to be realized or settled. As changes in tax
laws or rates are enacted, deferred tax assets and liabilities are adjusted
through the provision for income taxes. Low-income housing tax credits are
recognized in the year in which they are earned.
Investments in Real Estate Limited Partnerships
The Bank has investments in various real estate limited partnerships that
acquire, develop, own and operate low and moderate-income housing. The
Bank's ownership interest in these limited partnerships varies from 35% to
99.9% as of December 31, 1998. The Company consolidates the financial
statements of the limited partnership in which the Company is the general
partner, actively involved in management and has a controlling interest. The
Bank accounts for its investments in limited partnerships where the Bank
neither actively participates nor has a controlling interest under the
equity method of accounting.
Management periodically reviews the results of operations of the various
real estate limited partnerships to determine if the partnerships generate
sufficient operating cash flow to fund their current obligations. In
addition, management reviews the current value of the underlying property
compared to the outstanding debt obligations. If it is determined that the
investment suffers from a permanent impairment, the carrying value is
written down to the estimated realizable value.
Cash and Cash Equivalents
Cash and cash equivalents consist of cash on hand, amounts due from banks
and federal funds sold in the accompanying consolidated statements of cash
flows. At December 31, 1998 and 1997, cash and cash equivalents included
$2.5 million and $2.2 million, respectively, held to satisfy the reserve
requirements of the Federal Reserve Bank.
Other Real Estate Owned
Collateral acquired through foreclosure is recorded at the lower of cost or
fair value, less estimated costs to sell, at the time of acquisition. Bank
premises held for sale are recorded at the lower of cost or market, less
estimated costs to sell, at the date of transfer. Subsequent changes in the
fair value of other real estate owned are reflected as a write-down and
charged to expense. Net operating income or expense related to foreclosed
property and Bank premises held for sale is included in noninterest expense
in the accompanying consolidated statements of operations. There are
inherent uncertainties in the assumptions with respect to the estimated fair
value of other real estate owned. Because of these inherent uncertainties,
the amount ultimately realized on other real estate owned ("OREO") may
differ from the amounts reflected in the consolidated financial statements.
The Bank recognized losses due to write downs of $20 thousand, $34 thousand
and $2,495 thousand during 1998, 1997 and 1996, respectively. At December
31, 1998 the balance in the OREO portfolio consisted of foreclosed real
estate of $470 thousand.
Intangible Assets
Premiums paid for the purchase of core deposits are recorded as other assets
and amortized using a straight-line method over 15 years. Management reviews
the value of the intangible asset by comparing purchased deposit levels to
the current level of acquired deposits in the branches purchased. If any
significant deposit runoff has occurred and is determined to be permanent in
nature, the asset is written down accordingly.
Earnings Per Share
In 1997 the Company adopted Statement of Financial Accounting Standards
("SFAS") No. 128, "Earnings Per Share" which establishes new standards for
computing and presenting earnings per share ("EPS"). SFAS No. 128 applies to
entities with publicly held common stock or potential common stock. This
statement requires dual presentation of basic and diluted EPS on the face of
the income statement for all entities with complex capital structures and
requires a reconciliation of the numerators and denominators of the basic
and diluted EPS computations for all prior-period EPS data presented. Refer
to Note 11 for additional information.
Comprehensive Income
In June 1997, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 130, "Reporting Comprehensive Income". This statement establishes
standards for reporting and display of comprehensive income and its
components (revenues, expenses, gains and losses). Components of
comprehensive income are net income and all other non-owner changes in
equity. This statement requires that an enterprise (a) classify items of
other comprehensive income by their nature in a financial statement and (b)
display the accumulated balance of other comprehensive income separately
from retained earnings and additional paid-in capital in the equity section
of a statement of financial position. This statement is effective, and has
been adopted, for the Company's financial statements issued for the year
ended December 31, 1998.
Segment Information
In June 1997, the FASB issued SFAS No. 131, "Disclosures About Segments of
an Enterprise and Related Information". This statement establishes the
standards for reporting information about segments in annual and interim
financial statements. SFAS No. 131 introduces a new model for segment
reporting; the "management approach". The management approach is based on
the way the chief operating decision-maker organizes segments within a
company for making operating decisions and assessing performance. Reportable
segments are based on products and services, geography, legal structure,
management structure - any manner in which management disaggregates a
company. This statement is effective and has been adopted for the Company's
financial statements for the fiscal year ended December 31, 1998. Refer to
Note 14 for additional information.
Derivative Instruments and Hedging Activities
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities". This statement establishes standards
for reporting and accounting for derivative instruments ("derivatives") and
hedging activities. The statement requires that derivatives be reported as
assets or liabilities in the consolidated balance sheets and that
derivatives be reported at fair value. The statement establishes criteria
for accounting for changes in the fair value of derivatives based on the
intended use of the derivatives. The statement is effective for all quarters
of years beginning after June 15, 1999. Based on the Bank's current and
anticipated investment and hedging activities the Company does not expect
the adoption of SFAS No. 133 to have a material impact on the Company's
financial position or results of operations.
Reclassification
Certain amounts reported for prior periods have been reclassified to be
consistent with the current period presentation.
(2) INVESTMENT SECURITIES
Investments in debt securities are classified as trading, available for sale
or held to maturity as of December 31, 1998 and 1997. The amortized cost and
fair values of the debt securities classified as available for sale and held
to maturity as of December 31, 1998 and 1997 are as follows:
SECURITIES AVAILABLE FOR SALE:
Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
-----------------------------------------------------------------------------------
1998 (In thousands)
-----------------------------------------------------------------------------------
U.S. Agency Obligations $ 30,774 $ 481 $ 62 $ 31,193
Mortgage-backed Securities 41,058 130 176 41,012
-----------------------------------------------------------------------------------
$ 71,832 $ 611 $238 $ 2,205
===================================================================================
Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
-----------------------------------------------------------------------------------
1997 (In thousands)
-----------------------------------------------------------------------------------
U.S. Agency Obligations $ 31,058 $ 271 $ - $ 31,329
Mortgage-backed securities 12,825 105 18 12,912
-----------------------------------------------------------------------------------
$ 43,883 $ 376 $ 18 $ 44,241
===================================================================================
SECURITIES HELD TO MATURITY:
Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
-----------------------------------------------------------------------------------
1998 (In thousands)
U.S. Treasury Obligations $ 452 $ 13 $ - $ 465
U.S. Agency Obligations 14,979 84 - 15,063
Mortgage-backed Securities 88,420 1,786 17 90,189
-----------------------------------------------------------------------------------
$103,851 $1,883 $ 17 $105,717
===================================================================================
Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
-----------------------------------------------------------------------------------
1997 (In thousands)
-----------------------------------------------------------------------------------
U.S. Treasury Obligations $ 200 $ - $ - $ 200
U.S. Agency Obligations 12,526 94 4 12,616
Mortgage-backed Securities 98,732 960 41 99,651
-----------------------------------------------------------------------------------
$111,458 $1,054 $ 45 $112,467
===================================================================================
The fair value of securities held for trading was $1,095 thousand and $1,031
thousand at December 31, 1998 and 1997 respectively. Gains on securities
held for trading were $331 thousand and $267 thousand as of December 31,
1998 and 1997, respectively.
The contractual maturities of all debt securities held at December 31, 1998
are as follows:
Amortized Fair
(In thousands) Cost Value
-----------------------------------------------------------------
Due within one year $ 1,399 $ 1,405
Due after one year through five years 19,473 19,820
Due after five years through ten years 58,937 59,942
Due after ten years 95,874 96,755
-----------------------------------------------------------------
$175,683 $177,922
=================================================================
Proceeds from sales of available for sale debt securities were $14 million
and $18.9 million during 1998 and 1997, respectively. Gross gains of $44
thousand, $840 thousand and $120 thousand and gross losses of $0, $56
thousand and $87 thousand were realized from sales of securities in 1998,
1997 and 1996, respectively.
On November 29, 1996, $87.5 million of securities available for sale were
transferred to the held to maturity portfolio. Net unrealized gains of $219
thousand associated with these securities are being amortized over the
remaining lives of the individual securities.
At December 31, 1998, securities with a face value of $16.2 million were
pledged to secure public deposits, and for other purposes required by law.
(3) LOANS
The composition of the loan portfolio at December 31, 1998 and 1997 is as
follows:
(In thousands) 1997 1997
----------------------------------------------------------------
Commercial, Financial and Agricultural $ 63,953 $ 73,523
Real Estate-Commercial 170,892 181,018
Real Estate-Residential 147,348 111,270
Real Estate-Construction 8,091 8,695
Installment Loans to individuals 14,676 15,450
All Other Loans (including overdrafts) 532 432
----------------------------------------------------------------
Total Loans $405,492 $390,388
================================================================
The Bank currently originates primarily residential real estate loans,
commercial and installment loans, and commercial real estate loans to
customers throughout the state of Vermont. There were no loans held for sale
at December 31, 1998 and 1997. Substantially all of the Bank's loan
portfolio is based in the state of Vermont. There are no known significant
industry concentrations in the loan portfolio. Loans serviced for others at
December 31, 1998 and 1997 amounted to $160 million and $230 million,
respectively.
The reserve for possible loan losses is based on management's estimate of
the amount required to reflect the risks in the loan portfolio, based on
circumstances and conditions known or anticipated at each reporting date.
There are inherent uncertainties with respect to the final outcome of
certain of the Bank's loans and nonperforming assets. Because of these
inherent uncertainties, actual losses may differ from the amounts reflected
in these consolidated financial statements. Factors considered in evaluating
the adequacy of the reserve include previous loss experience, current
economic conditions and their effect on the borrowers, the performance of
individual loans in relation to contract terms, and estimated fair values of
properties to be foreclosed. Losses are charged against the reserve for loan
losses when management believes that the collectibility of principal is
doubtful. To the extent management determines the level of anticipated
losses in the portfolio have significantly increased or diminished the
reserve is adjusted through current earnings.
Key elements of the above estimates, including those used in independent
appraisals, are dependent upon the economic conditions prevailing at the
time of the estimates. Accordingly, uncertainty exists as to the final
outcome of certain of the valuation judgments. The inherent uncertainties in
the assumptions relative to the projected sales prices or rental rates may
result in the ultimate realization of amounts on certain loans that are
different from the amounts reflected in these consolidated financial
statements.
An analysis of the reserve for possible loan losses for the years ended
December 31, 1998 and 1997 is as follows:
(In thousands) 1998 1997
----------------------------------------------------------
Balance, Beginning of Year $15,831 $15,700
Provision for Possible Loan Losses (1,737) (1,862)
Loans Charged Off (3,935) (1,696)
Recoveries 1,141 3,689
----------------------------------------------------------
Balance, End of Year $11,300 $15,831
==========================================================
The allowance for possible loan losses related to loans that are identified
as impaired is based on discounted cash flows using the loan's effective
interest rate or the fair value of the collateral for certain collateral
dependent loans. The Company has determined that commercial and commercial
real estate loans recognized by the Company as nonaccrual, loans past due
over 90 days and still accruing, restructured troubled debt and certain
internally adversely classified loans are generally equivalent to impaired
loans.
Total impaired loans at December 31, 1998 and 1997 with a related allowance
were $3.9 million and $4.8 million respectively, and the allowance
associated with such loans was $400 thousand and $665 thousand,
respectively. Interest payments on impaired loans are generally recorded as
principal reductions if the remaining loan balance is not expected to be
paid in full. If full collection of the remaining loan balance is expected,
payments are recognized as interest income on a cash basis. During 1998 and
1997, the Company recorded interest income on impaired loans of
approximately $240 thousand and $394 thousand, respectively. The average
balance of impaired loans was $6.9 million in 1998 and $7.9 million in 1997.
Nonperforming assets at December 31, 1998 and 1997 were as follows:
(In thousands) 1998 1997
----------------------------------------------------
Nonaccrual loans $2,103 $2,686
Restructured Loans 320 215
Loans Past Due 90 Days or More
and Still Accruing Interest 170 403
----------------------------------------------------
Total Nonperforming Loans 2,593 3,304
Other Real Estate Owned, Net 470 591
----------------------------------------------------
Total Nonperforming Assets $3,063 $3,895
====================================================
The Bank had $320 thousand and $215 thousand of restructured loans that were
performing in accordance with the modified agreement at December 31, 1998
and 1997, respectively.
The Bank's policy is to discontinue the accrual of interest and reverse
uncollected interest receivable on loans when scheduled payments become
contractually past due in excess of 90 days or, in the judgment of
management, the ultimate collectibility of principal or interest becomes
doubtful.
The amount of interest which was not earned but which would have been earned
had the nonaccrual and restructured loans performed in accordance with their
original terms and conditions was approximately $441 thousand, $395 thousand
and $1,493 thousand in 1998, 1997 and 1996, respectively.
During 1998 the Bank consummated transactions involving sales of loans,
including certain impaired loans. The aggregate net book value of loans sold
was approximately $15.1 million. The Bank recognized total income of $357
thousand from the sale of these loans. During 1997, the Bank consummated two
such transactions, including certain impaired loans. The aggregate net book
value of loans sold in 1997 was approximately $2.7 million, resulting in a
gain on sales of $396 thousand, which was credited to the reserve for
possible loan losses. All loans were sold without recourse.
An analysis of loans to directors, executive officers, and associates of
such persons for the year ended December 31, 1998 is as follows:
(In thousands)
-------------------------------------
Balance, December 31, 1997 $8,950
Additions 718
Repayments (783)
-------------------------------------
Balance, December 31, 1998 $8,885
=====================================
It is the policy of the Bank to grant such loans on substantially the same
terms, including interest rates and collateral, as those prevailing for
comparable lending transactions with other persons. The December 31, 1998
balance has been adjusted to reflect changes in status of directors and
executive officers during 1998.
(4) PREMISES AND EQUIPMENT
The components of premises and equipment included in the accompanying
consolidated balance sheets are as follows:
(In thousands) 1998 1997
----------------------------------------------------------
Land and Buildings $12,926 $12,601
Leasehold Improvements 1,221 1,288
Furniture, Equipment, and Software 10,322 10,617
----------------------------------------------------------
24,469 24,506
Less: Accumulated Depreciation
and Amortization 11,284 11,078
----------------------------------------------------------
$13,185 $13,428
==========================================================
Depreciation and amortization expense related to premises and equipment
amounted to $2.2 million, $2.0 million and $1.7 million in 1998, 1997, and
1996, respectively.
The Bank leases certain properties for branch operations. Rent expense on
these properties totaled $303 thousand, $263 thousand and $240 thousand for
the years ended December 31, 1998, 1997 and 1996, respectively. Minimum
lease payments for these properties subsequent to December 31, 1998 are as
follows: 1999-$329 thousand; 2000-$293 thousand; 2001-$286 thousand; 2002-
$242 thousand; 2003-$180 thousand and $288 thousand thereafter.
(5) EMPLOYEE BENEFIT PLANS
Pension Plan
Prior to January 1995, the Company maintained a noncontributory defined
benefit plan covering all eligible employees. The plan was a final average
pay plan with benefits based on the average salary rates over the five
consecutive plan years out of the last ten consecutive plan years that
produce the highest average. It was the Company's policy to fund the cost of
benefits expected to accrue during the year plus amortization of any
unfunded accrued liability that had accumulated prior to the valuation date
based on IRS regulations for funding. During 1994, the Company made the
decision to freeze the plan beginning on January 1, 1995. During 1995, the
plan was curtailed. Accordingly, all accrued benefits were fully vested and
no additional years of service or age will be accrued.
The plan's funded status and amounts recognized in the accompanying
consolidated balance sheets and statements of operations as of December 31,
1998 and 1997 are as follows:
(In thousands) 1998 1997
-----------------------------------------------------------------------
Change in Projected Benefit Obligation
Projected Benefit Obligation at Beginning of Year $6,610 $5,180
Interest Cost 465 452
Actuarial Gain 473 1,444
Benefits Paid (475) (466)
-----------------------------------------------------------------------
Projected Benefit Obligation at Year End $7,073 $6,610
-----------------------------------------------------------------------
Change in Plan Assets
Fair Value of Plan Assets at Beginning of Year $7,308 $6,778
Actuarial Return on Plan Assets 866 996
Benefits Paid (475) (466)
-----------------------------------------------------------------------
Fair Value of Plan Assets at Year End $7,699 $7,308
-----------------------------------------------------------------------
Funded Status of the Plan
Amount Over Funded $ 626 $ 698
Unrecognized Net Actuarial Loss 771 602
Unrecognized Prior Service Cost (15) (54)
-----------------------------------------------------------------------
Net Amount Recognized $ 756 $ 548
-----------------------------------------------------------------------
Amounts Recognized in the Statements of
Financial Position Consist of the Following:
Prepaid Benefit Cost $1,382 $1,246
=======================================================================
A summary of (income) expense relating to the Company's pension fund for
each of the three years in the period ended December 31, 1998 is as follows:
(In thousands) 1998 1997 1996
---------------------------------------------------------------------
Interest Cost on Projected Benefit
Obligation $ 465 $ 452 $ 402
Expected Return on Plan Assets (530) (563) (507)
Amortization of Unrecognized Transition
Asset (39) (39) (39)
Recognized Net Losses 4 - -
---------------------------------------------------------------------
Net Periodic Pension Costs $(100) $(150) $(144)
=====================================================================
The actuarial present value of the projected benefit obligation was
determined using a weighted average discount rate of 6.75%, 7% and 7.6% as
of December 31, 1998, 1997 and 1996, respectively. For 1998, 1997 and 1996
there was no assumed rate of increase in future compensation due to the
freeze on plan benefits. The expected long-term rate of return on assets
used was 8% in 1998, 8% in 1997 and 9% in 1996.
Employee Stock Ownership Plan/401(k) Plan
Under the terms of the Company's Employee Stock Ownership Plan (ESOP),
eligible employees are entitled to contribute up to 15% of their
compensation to the ESOP, and the Company contributes a percentage of the
amounts contributed by the employees, as authorized by the Company's Board
of Directors. The Company contributed approximately 128% and 126%,
respectively, of the amounts contributed by the employees (200% of up to
4.5% of individual employee compensation) in 1998 and 1997. Substantially
all employer contributions to the ESOP are funded with cash and are used to
purchase the Company's common stock.
Deferred Compensation Plans
Until July 1, 1997, Directors of the Bank were entitled to defer a portion
of their compensation into a Deferred Compensation Plan for Directors known
as the "Floating Growth (savings)" program. The Board of Directors voted at
their February 1997 meeting to amend the Plan to provide that no additional
compensation may be deferred into the Floating Growth (savings) program
after July 1, 1997. Benefits accrue based on the Directors' fees deferred
and a monthly allowance for interest at a rate that is fixed from time to
time at the discretion of the Board of Directors. The benefits under the
Floating Growth (savings) program of the Deferred Compensation Plan for
Directors and the New Plans are generally payable starting on the January 2
following a participant's 65th birthday or earlier death, and will be
distributed to the participant (or upon the participant's death, to the
participant's designated beneficiary) in accordance with the Plan.
A summary of (income) expense relating to the Company's various employee
benefit plans for each of the three years in the period ended December 31,
1998 is as follows:
(In thousands) 1998 1997 1996
-----------------------------------------------------------
Pension Plan $(100) $(150) $(144)
Employee Stock Ownership
Plan/401(k) Plan 588 685 653
Deferred Compensation Plans 11 20 27
-----------------------------------------------------------
Total $ 499 $ 555 $ 536
===========================================================
(6) STOCK-BASED COMPENSATION PLANS
Stock Option Plans
The Company has granted stock options to certain key employees. The options
granted vest after two years and are immediately exercisable upon vesting.
Nonqualified stock options may be granted at any price determined by the
Compensation Committee of the Board of Directors. All stock options have
been granted at or above fair market value at the date of grant.
A summary of the Company's stock option activity is as follows
1998 1997 1996
-----------------------------------------------------------------------------------------------
Weighted Weighted Option
Number Average Number Average Number Price
of Exercise of Exercise of Per
Shares Price Shares Price Shares Share
-----------------------------------------------------------------------------------------------
(In thousands except per share data)
Options outstanding,
Beginning of year 103 $21.88 50 $12.45 40 $11.72
Granted 48 $30.50 71 $25.69 10 $15.38
Exercised 13 $12.61 18 $10.72 - -
-----------------------------------------------------------------------------------------------
Options outstanding,
end of year 138 $25.76 103 $21.88 50 $12.45
Options exercisable 19 $13.98 22 $12.53 20 $11.00
Weighted average fair value
per option of options
granted during year $ 6.92 $ 6.71 $ 6.83
-----------------------------------------------------------------------------------------------
As of December 31, 1998, the exercisable options outstanding were
exercisable at prices ranging from $10.00 to $15.37 and had a weighted-
average remaining contractual life of 3.8 years.
In October, 1995 the FASB issued SFAS No. 123, "Accounting for Stock Based
Compensation" ("SFAS No. 123"), which establishes a fair value based method
of recognizing stock-based compensation expense. As permitted by SFAS No.
123, the Company has elected to continue to apply APB No. 25 to account for
its stock-based compensation plans. Had compensation cost for awards under
the Company's stock-based compensation plans been determined consistent with
the method set forth under SFAS No. 123, the effect on the Company's net
income and earnings per share would have been as follows:
1998 1997
--------------------------------------------------------------------------------------
As Reported Pro Forma As Reported Pro Forma
--------------------------------------------------------------------------------------
(In thousands except per share data)
Net Income $9,822 $9,712 $8,833 $8,679
Basic Earnings per Share $ 2.22 $ 2.19 $ 2.00 $ 1.97
Diluted Earnings per Share $ 2.21 $ 2.19 $ 1.99 $ 1.96
--------------------------------------------------------------------------------------
Because the method prescribed by SFAS No. 123 has not been applied to
options granted prior to January 1, 1995, the resulting pro forma
compensation expense may not be representative of the amount to be expected
in future years. Pro forma compensation expense for options granted is
reflected over the vesting period; therefore, future pro forma compensation
expense may be greater as additional options are granted.
The fair value of each option grant is estimated on the grant date using the
Black-Scholes option-pricing model with the following weighted-average
assumptions used for grants in 1998 and 1997, respectively: Risk-free
interest rates of 4.59% for 1998 and 6.0% 1997; expected lives of options of
5 years for 1998 and 4 years for 1997; expected volatility of stock of
30.05% for 1998 and 34.37% for 1997; rate of dividends of 2.53% for 1998
and 2.48% for 1997; and pro-forma after tax compensation expense of $110
thousand for 1998 and $308 thousand for 1997.
The Black-Scholes option-pricing model was developed for use in estimating
the fair value of traded options that have no vesting restrictions and are
fully transferable. In addition, option-pricing models require the input of
highly subjective assumptions. Because the Company's employee stock options
have characteristics significantly different from those of traded options,
and because changes in the subjective input assumptions can materially
affect the fair value estimate, in management's opinion, the existing models
do not necessarily provide a reliable single measure of the fair value of
its employee stock options.
Deferred Compensation Plans
Through December 1995, the Bank maintained an Executive Salary Continuation
Plan and a Deferred Compensation Plan for Directors. In December 1995, the
Bank and participants in its Executive Salary Continuation Plan and in the
Fixed Growth Program of its Deferred Compensation Plan for Directors agreed
to amend or terminate the existing plans. In satisfaction of all liabilities
under those plans, the Bank agreed to make payments to, or credits for, the
participants. Pursuant to these agreements, the Bank established several new
plans (the "New Plans") and established certain trusts (the "Trusts") with
Merchants Trust Company, to which it contributed an amount sufficient to
cover the Bank's obligations under the New Plans. The New Plans used those
payments, in part, to purchase newly issued common stock of the Company at
its market price. The purchases have been accounted for as treasury stock
transactions in the Company's consolidated financial statements. The
portions of the payments made to the New Plans that were not invested in the
common stock of the Company are included as investments in the consolidated
financial statements and are classified as trading. In conjunction with the
amendment and termination of the existing plans, the Bank either sold or
surrendered certain life insurance policies and used the proceeds as a
partial source to fund the lump sum payments made to the New Plans. To the
extent the obligations of the Company under the New Plans are based on
investments by the New Plans in other than shares of the Company, the
investments are revalued at each reporting date with a corresponding
adjustment to compensation expense. In addition, the obligation related to
certain Company shares, originally purchased for $200 thousand, were
revalued at each reporting date, with a corresponding adjustment to
compensation expense. These Company shares were sold during December 1997.
In July 1998, the Emerging Issues Task Force ("EITF") issued guidance on
Issue No. 97-14, "Accounting for Deferred Compensation Arrangements Where
Amounts Earned Are Held in a Rabbi Trust and Invested" (the "Guidance").
This Guidance establishes standards for reporting and accounting for certain
deferred compensation agreements between the Company and certain of its
directors. This Guidance requires that the deferred compensation obligation
be classified in the "Stockholders' Equity" section of the balance sheets.
These amounts were previously classified as other liabilities in the
"Liabilities" section of the balance sheets. The Company adopted this
guidance prospectively on September 30, 1998 and on that date reclassified
deferred compensation obligations totaling $2.13 million to a component
within Stockholders' Equity labeled "Deferred Compensation Arrangements".
Restricted Stock Plans
The Company and the Bank adopted new compensation plans for non-employee
directors during 1997. Under the terms of the plans, participating directors
may elect to have all or a specified percentage of his or her compensation
for a given year paid in the form of cash or deferred in the form of shares
of restricted common stock of the Company. Directors who elect to have their
compensation deferred shall be credited with a number of shares of the
Company's stock equal in value to the amount of fees deferred plus a risk
premium of not more than 25% of the amount deferred. The participating
director may not generally sell, transfer or otherwise dispose of these
shares, prior to the fifth anniversary of the date of the grant of such
shares. With respect to shares of common stock issued or otherwise
transferred to a participating director, the participating Director will
have the right to vote the shares and receive dividends or other
distributions thereon. If a participating Director resigns under certain
circumstances the Director shall forfeit all of his or her restricted
shares, which are risk premium shares. During 1998, 5,200 shares of common
stock of the Company were distributed to a trust established under the terms
of the new compensation plan. The "risk premium" is reflected within a
component of Stockholders' Equity labeled "Deferred Compensation
Arrangements" and will be recognized as an expense ratably over the five-
year restriction period.
(7) INCOME TAXES
The provision (benefit) for income taxes for each of the three years in the
period ended December 31, 1998 consists of the following:
(In thousands) 1998 1997 1996
----------------------------------------------------
Current $3,065 $1,499 $ 3,307
Deferred (Prepaid) 183 884 (1,475)
----------------------------------------------------
$3,248 $2,383 $ 1,832
====================================================
Prepaid and deferred income taxes result from differences between the income
for financial reporting and tax reporting relating primarily to the
provision for possible loan losses. The net deferred tax asset amounted to
approximately $4.2 million and $4.4 million at December 31, 1998 and 1997,
respectively. This tax asset is included in other assets in the accompanying
consolidated balance sheets.
The components of the net deferred tax asset as of December 31, 1998 and
1997 are as follows:
(In thousands) 1997 1996
-----------------------------------------------------------------------
Reserve for Possible Loan Losses $ 4,064 $ 5,605
Deferred Compensation 1,340 1,335
Unrealized Securities Gains (191) (197)
Loan Fees 104 191
Depreciation (876) (599)
Accrued Liabilities 46 (335)
Capital Loss Carryforwards - 618
Investments in Real Estate Limited Partnerships (968) (712)
Excess Servicing Right (17) (31)
Loan Market Adjustment (2,932) (4,505)
Other (975) (1,131)
Tax Credit Carryforwards 4,190 4,293
Core Deposit Intangible 472 526
-----------------------------------------------------------------------
4,257 5,058
Valuation Allowance - (618)
-----------------------------------------------------------------------
$ 4,257 $ 4,440
=======================================================================
A valuation allowance is provided when it is more likely than not that some
portion of the net prepaid tax asset will not be realized. The Company had
established a valuation allowance for capital loss carryforwards since such
losses may only be utilized against future capital gains.
The following is a reconciliation of the federal income tax provision
(benefit), calculated at the statutory rate, to the recorded provision
(benefit) for income taxes:
(In thousands) 1997 1996 1995
--------------------------------------------------------------------------
Applicable Statutory Federal Income
Tax $ 4,444 $ 3,779 $ 2,739
(Reduction) Increase in Taxes
Resulting From:
Gain (Loss) on Investment Securities - (134) 27
Tax-exempt Income (41) (55) (74)
Tax Credits (1,328) (1,089) (980)
Other, Net 173 (118) 120
--------------------------------------------------------------------------
$ 3,248 $ 2,383 $ 1,832
==========================================================================
The state of Vermont assesses a franchise tax for banks in lieu of income
tax. The franchise tax is assessed based on deposits and amounted to
approximately $590 thousand, $386 thousand, and $255 thousand in 1998, 1997,
and 1996, respectively. These amounts are included in other expenses in the
accompanying consolidated statements of operations. The Company received
refunds of its 1995, 1994, and 1993 Vermont Franchise Taxes of $797 thousand
during 1996.
(8) OTHER BORROWED FUNDS
Other borrowed funds consist of the following at December 31, 1998 and 1997:
(In thousands) 1998 1997
-------------------------------------------------
Treasury Tax and Loan Notes $ 283 $4,000
Short Term Borrowing 9,000 4,000
-------------------------------------------------
$9,283 $8,000
=================================================
As of December 31, 1998, the Bank may borrow up to $35 million in overnight
funds on an unsecured basis.
The following table provides certain information regarding other borrowed
funds for the two years ended December 31, 1998 and 1997:
Maximum Weighted
Month-End Average Average Rate Weighted
Amount Amount During Average Rate
(In thousands) Outstanding Outstanding the Year at Year End
---------------------------------------------------------------------------------------------
1998
Treasury Tax and Loan Notes $ 4,000 $1,939 5.14% 4.12%
Federal Funds Purchased 6,000 730 5.70% -
Short Term Borrowing 20,000 2,986 5.68% 5.66%
---------------------------------------------------------------------------------------------
1997
Treasury Tax and Loan Notes $ 4,182 $2,413 5.39% 5.27%
Federal Funds Purchased 3,850 906 5.99% -
Short Term Borrowing 15,000 4,880 5.87% 6.16%
---------------------------------------------------------------------------------------------
(9) DEBT
Debt consists of the following at December 31, 1998 and 1997:
(In thousands) 1998 1997
------------------------------------------------------------------------------
9% Note Payable, Monthly Installments of
$1.7 thousand (Principal and Interest), Annual
Installments of $30 Thousand (Principal only) , Through
July 2003 $ 197 $ 200
8.75% Mortgage Note, payable in Monthly Installments of
$2.5 thousand (Principal and Interest) Through 2039 1,182 1,185
Federal Home Loan Bank Notes Payable, Interest Rates
From 7.52% to 8.66% Due in 2001 5,030 5,030
------------------------------------------------------------------------------
$ 6,409 $6,415
==============================================================================
The 8.75% mortgage note relates to a low-income housing project. The monthly
installments are subsidized by the U.S. Department of Agriculture, which
pays amounts annually so as to reduce the monthly principal and interest
payments to an amount equivalent to a loan at a rate of 1%.
Maturities of debt subsequent to December 31, 1998 are as follows: 1999-$37
thousand; 2000-$41 thousand; 2001-$5,075 thousand; 2002-$49 thousand; 2003-
$44 thousand and $1,163 thousand thereafter.
As of December 31, 1998, the Company is in compliance with all of the
covenants of the Federal Home Loan Bank ("FHLB") agreements.
(10) STOCKHOLDERS' EQUITY
Vermont state law requires the Bank to appropriate a minimum of 10% of net
income to surplus until such time as appropriated amounts equal 10% of
deposits and other liabilities. The Company's stockholders' equity includes
$9.0 million as of December 31, 1998 and $8.1 million as of December 31,
1997 of such appropriations. Vermont state law also restricts the payment of
dividends under certain circumstances.
(11) EARNINGS PER SHARE
The following table presents a reconciliation of the calculations of basic
and diluted earnings per share for the year ended December 31, 1998:
Per Share
1998 Income Shares Amount
---------------------------------------------------------------------------------------------
(In thousands except share and per share data)
Basic Earnings Per Share:
Income Available to Common Shareholders $9,822 4,425,031 $2.22
Diluted Earnings Per Share:
Options issued to Executives (See Note 6) - 15,034
Income Available to Common Shareholders
Plus Assumed Conversions $9,822 4,440,065 $2.21
=============================================================================================
Per Share
1997 Income Shares Amount
---------------------------------------------------------------------------------------------
(In thousands except share and per share data)
Basic Earnings Per Share:
Income Available to Common Shareholders $8,833 4,423,153 $2.00
Diluted Earnings Per Share:
Options issued to Executives (See Note 6) - 23,256
Income Available to Common Shareholders
Plus Assumed Conversions $8,833 4,446,409 $1.99
=============================================================================================
Basic earnings per common share were computed by dividing net income by the
weighted average number of shares of common stock outstanding during the
year. Upon adoption of SFAS No. 128 the Company's reported earnings per
share for 1996 were restated. There was no effect on earnings per share for
1996.
(12) COMMITMENTS AND CONTINGENCIES
The Bank is a counterclaim defendant in a litigation entitled Pasquale and
Vatsala Vescio, Counterclaim Plaintiffs v. The Merchants Bank, Counterclaim
Defendant, now pending in the United States Bankruptcy Court for the
District of Vermont.
In this litigation, the Vescios have made a number of "lender liability"
claims dealing with a commercial development known as Brattleboro West in
Brattleboro, Vermont. The pending litigation arose out of a suit to
foreclose on several real estate mortgages and personal property originally
delivered to the Bank as collateral by the Vescios in connection with the
financing of a supermarket in the Brattleboro West project and various other
projects.
Among other things, the Vescios have alleged that the Bank or its
representatives violated supposed oral promises in connection with the
origination and funding of the financing, and have claimed that the Bank is
liable to them for damages based on the Bank's supposed "control" of the
project and its alleged breach of covenants of "good faith" which the
plaintiffs believe are to be implied from the loan documents. In addition,
the plaintiffs have contended that the Bank breached a duty of care they
believe it owed to them, and have claimed that the Bank should not have
exercised its contract rights when the loan went into default, but should
have worked out the default in a way that was more favorable to the
borrowers. Trial concluded in United States Bankruptcy Court in November
1998. Although it is not possible at this stage to predict the outcome of
this litigation, the Bank believes that it has meritorious defenses to the
plaintiffs' allegations. The Bank intends to vigorously defend itself
against these claims.
The Company, the Bank, the Trust Company (the "Companies") and certain of
their directors are defendants in a lawsuit filed in November 1994 (the
"Vermont Proceedings"). The Vermont Proceedings arose from certain
investments managed for Trust Company customers and placed in the Piper
Jaffray Institutional Government Income Portfolio (the "Portfolio"). In
December 1994, the Companies made payments to the Trust Company customers in
amounts that the Companies believed reimbursed those customers fully for
Portfolio losses. The United States District Court for the District of
Vermont has dismissed the Plaintiff's claims in the Vermont Proceedings with
prejudice, as moot, and ordered payment of approximately $99,000 in
attorney's fees. The Plaintiff and his attorneys appealed those District
Court orders to the Second Circuit Court of Appeals, and the Companies
appealed on certain limited issues. By Order dated January 28, 1999 the
Second Court affirmed those District Court orders in all material respects
and remanded the case to the District Court with instructions to clarify
whether the dismissal of the claims as moot was to be with prejudice. Still
pending before the Second Circuit is a separate appeal from the District
Court's denial of Plaintiff's requests for sanctions and other relief based
on asserted improprieties in the defense of the litigation. The Companies
believe the Plaintiff's assertions in that regard are groundless and will
continue to seek denial of Plaintiff's requests.
The Companies have separately pursued claims against others on account of
the losses suffered as a result of the investments in the Portfolio. Claims
against Piper Jaffray Companies, Inc. were joined with the claims of others
in a class action in the United States District Court for the District of
Minnesota (the "Minnesota Proceedings"). The Minnesota Proceedings were
settled by the parties and in February of 1997 the District Court ordered
the net share of the settlement proceeds attributable to the Trust Company's
investments to be paid to the Trust Company, starting approximately 60 days
after the Court's order becomes final, except to the extent, if at all, any
other court with jurisdiction has sooner given leave for some or all of
those payments to be deposited with such other court pursuant to applicable
rules. The attorneys representing the Plaintiff in the Vermont Proceedings
and also representing, in the Minnesota Proceedings, the beneficiaries of
four other Trust Company accounts, appealed that order to the Eighth Circuit
Court of Appeals. By Per Curiam decision filed July 25, 1998, the Eighth
Circuit denied that appeal. The attorneys for the Plaintiffs have filed a
petition for certiorari to the United States Supreme Court, which has not
yet acted upon it. The same attorneys also have announced an intention to
initiate separate proceedings to seek to intercept at least a portion of any
payments coming from the Minnesota Proceedings, in order to seek to deprive
the Companies of at least a portion of the reimbursement that otherwise
could be available. Any recovery by the Companies from the Minnesota
Proceedings is subject to the terms of an agreement between the Companies
and their insurance carrier, which reimbursed the Companies, in part, for
the December, 1994 payments.
Merchants Bancshares, Inc. and certain of its subsidiaries have been named
as defendants in various other legal proceedings arising from their normal
business activities. Although the amount of any ultimate liability with
respect to such proceedings cannot be determined, in the opinion of
management, based upon the opinion of counsel on the outcome of such
proceedings, any such liability will not have a material effect on the
consolidated financial position of Merchants Bancshares, Inc. and its
subsidiaries.
(13) PARENT COMPANY
The Parent Company's investments in its subsidiaries are recorded using the
equity method of accounting. Summarized financial information relative to
the Parent Company only balance sheets at December 31, 1998 and 1997 and
statements of operations and cashflows for each of the three years in the
period ended December 31, 1998 are as follows:
Balance Sheets as of December 31
(In thousands) 1998 1997
- ---------------------------------------------------------------------
Assets:
Investment in and Advances to Subsidiaries* $60,329 $54,703
Other Assets 511 1,337
- ---------------------------------------------------------------------
Total Assets $60,840 $56,040
=====================================================================
Liabilities and Equity Capital:
Other Liabilities $ 11 $ 3,104
Equity Capital 60,829 52,936
- ---------------------------------------------------------------------
Total Liabilities and Equity Capital $60,840 $56,040
=====================================================================
Statements of Operations for the Years Ended December 31
(In thousands) 1998 1997 1996
- --------------------------------------------------------------------------------------
Dividends from Merchants Bank* $4,000 $2,267 $ -
Equity in Undistributed Earnings of Subsidiaries 5,907 6,652 6,306
Other Expense, Net (129) (130) (125)
Benefit from Income Taxes 44 44 43
- --------------------------------------------------------------------------------------
Net Income $9,822 $8,833 $6,224
======================================================================================
<FN>
- --------------------
<F*> Account balances are partially or fully eliminated in consolidation.
</FN>
Statements of Cash Flows for the Years Ended December 31
(In thousands) 1998 1997 1996
- --------------------------------------------------------------------------------------
Cash Flows from Operating Activities:
Net Income $ 9,822 $ 8,833 $ 6,224
Adjustments to Reconcile Net Income to Net Cash
Provided by Operating Activities:
Decrease in Miscellaneous Receivables 71 89 99
Increase (Decrease) in Miscellaneous Payables (2) 40 -
Equity in Undistributed Income of Subsidiaries (5,907) (6,652) (6,306)
- --------------------------------------------------------------------------------------
Net Cash Provided by Operating Activities 3,984 2,310 17
- --------------------------------------------------------------------------------------
Cash Flows From Financing Activities:
Sale of Treasury Stock 80 1,234 -
Acquisition of Treasury Stock (1,420) (1,390) -
Proceeds from Exercise of Employee Stock Options 164 42 -
Tax Benefit from Employee Stock Option Exercise 60 - -
Dividends Paid (3,051) (2,217) -
Other, Net 75 (35) -
- --------------------------------------------------------------------------------------
Net Cash Used in Financing Activities (4,092) (2,366) -
- --------------------------------------------------------------------------------------
Increase (Decrease) in Cash and Cash Equivalents (108) (56) 17
Cash and Cash Equivalents at Beginning of Year 262 318 301
- --------------------------------------------------------------------------------------
Cash and Cash Equivalents at End of Year $ 154 $ 262 $ 318
======================================================================================
Total Interest Payments $ - $ - $ -
Taxes Paid 2,170 3,820 -
- --------------------------------------------------------------------------------------
(14) BUSINESS SEGMENTS
On January 1, 1998 the Company adopted Statement of Financial Accounting
Standards No. 131, "Disclosures about Segments of an Enterprise and Related
Information" ("SFAS No. 131"). The adoption of SFAS No. 131 did not have a
material effect on the Company's primary financial statements.
The Company has identified Community Banking as its reportable operating
business segment. The Community Banking business segment consists of
commercial banking and retail banking. The Community Banking business
segment is managed as a single strategic unit which derives its revenues
from a wide range of banking services, including lending activities,
acceptance of demand, savings and time deposits, safe deposit facilities,
merchant card services and mortgage servicing income from investors.
Non-reportable operating segments of the Company's operations which do not
have similar characteristics to the Community Banking segment and do not
meet the quantitative thresholds requiring disclosure are included in the
Other category in the disclosure of business segments below. These non-
reportable segments include Trust and Investment Services, as well as parent
company financial information (Note 13).
The following tables present the results of the Company's reportable
operating business segment results as of December 31, 1998, 1997 and 1996:
Community Consolidation
December 31, 1998 Banking Other Adjustment Consolidated
- -----------------------------------------------------------------------------------------------
Interest Income $ 47,990 $ 33 $ - $ 48,023
Interest Expense 18,501 29 - 18,530
Provision for Possible Loan Losses (1,737) - - (1,737)
- -----------------------------------------------------------------------------------------------
Net Interest Income After Provi-
sion for Possible Loan Losses 31,226 4 - 31,230
- -----------------------------------------------------------------------------------------------
Noninterest Income:
Trust Company Income - 1,910 - 1,910
Service Charges on Deposits 2,756 - - 2,756
Merchants Discount Fees 1,444 - - 1,444
Other 1,074 128 - 1,202
- -----------------------------------------------------------------------------------------------
Total Noninterest Income 5,274 2,038 - 7,312
- -----------------------------------------------------------------------------------------------
Noninterest Expenses:
Salaries and Employee Benefits 10,780 690 - 11,470
Occupancy and Equipment 4,474 93 - 4,567
Legal and Professional 2,220 227 - 2,447
Other Expenses 6,523 465 - 6,988
- -----------------------------------------------------------------------------------------------
Total Noninterest Expenses 23,997 1,475 - 25,472
- -----------------------------------------------------------------------------------------------
Income Before Provision For
Income Taxes 12,503 567 - 13,070
- -----------------------------------------------------------------------------------------------
Provision for Income Taxes 2,994 254 - 3,248
- -----------------------------------------------------------------------------------------------
Net Income $ 9,509 $ 313 $ - $ 9,822
===============================================================================================
End of Period Securities $178,539 $ 1,094 $ - $179,633
End of Period Net Loans 394,192 - - 394,192
End of Period Assets 632,613 67,280 (65,020) 634,873
End of Period Deposits 552,351 - (1,889) 550,462
End of Period Borrowings 14,510 1,182 - 15,692
End of Period Liabilities 573,394 2,539 (1,889) 574,044
- -----------------------------------------------------------------------------------------------
Community Consolidation
December 31, 1997 Banking Other Adjustment Consolidated
- -----------------------------------------------------------------------------------------------
Interest Income $ 48,155 $ 3 $ - $ 48,158
Interest Expense 18,238 - - 18,238
Provision for Possible Loan Losses (1,862) - - (1,862)
- -----------------------------------------------------------------------------------------------
Net Interest Income After Provi-
sion for Possible Loan Losses 31,779 3 - 31,782
- -----------------------------------------------------------------------------------------------
Noninterest Income:
Trust Company Income - 1,635 - 1,635
Service Charges on Deposits 3,075 - - 3,075
Merchants Discount Fees 1,537 - - 1,537
Other 1,599 70 - 1,669
- -----------------------------------------------------------------------------------------------
Total Noninterest Income 6,211 1,705 - 7,916
- -----------------------------------------------------------------------------------------------
Noninterest Expenses
Salaries and Employee Benefits 9,967 707 - 10,674
Occupancy and Equipment 4,460 36 - 4,496
Legal and Professional 3,486 402 - 3,888
Other Expenses 8,462 962 - 9,424
- -----------------------------------------------------------------------------------------------
Total Noninterest Expenses 26,375 2,107 - 28,482
- -----------------------------------------------------------------------------------------------
Income Before Provision For
Income Taxes 11,615 (399) - 11,216
Provision for Income Taxes 2,375 8 - 2,383
- -----------------------------------------------------------------------------------------------
Net Income $ 9,240 $ (407) $ - $ 8,833
===============================================================================================
End of Period Securities $157,996 $ 1,030 $ - $159,026
End of Period Net Loans 374,557 - - 374,557
End of Period Assets 583,575 62,243 (61,566) 584,252
End of Period Deposits 508,778 - (2,934) 505,844
End of Period Borrowings 13,231 1,184 - 14,415
End of Period Liabilities 529,674 4,576 (2,934) 531,316
- -----------------------------------------------------------------------------------------------
Community Consolidation
December 31, 1996 Banking Other Adjustment Consolidated
- -----------------------------------------------------------------------------------------------
Interest Income $ 48,001 $ 3 $ - $ 48,004
Interest Expense 18,644 28 - 18,672
Provision for Possible Loan Losses 3,150 - - 3,150
- -----------------------------------------------------------------------------------------------
Net Interest Income After Provi-
sion for Possible Loan Losses 26,207 (25) - 26,182
- -----------------------------------------------------------------------------------------------
Noninterest Income:
Trust Company Income - 1,493 - 1,493
Service Charges on Deposits 3,347 - - 3,347
Merchants Discount Fees 1,696 - - 1,696
Other 2,676 151 - 2,827
- -----------------------------------------------------------------------------------------------
Total Noninterest Income 7,719 1,644 - 9,363
- -----------------------------------------------------------------------------------------------
Noninterest Expenses
Salaries and Employee Benefits 9,391 622 - 10,013
Occupancy and Equipment 4,054 24 - 4,078
Legal and Professional 1,486 475 - 1,961
Other Expenses 10,911 526 - 11,437
- -----------------------------------------------------------------------------------------------
Total Noninterest Expenses 25,842 1,647 - 27,489
- -----------------------------------------------------------------------------------------------
Income Before Provision For
Income Taxes 8,084 (28) - 8,056
Provision for Income Taxes 1,824 8 - 1,832
- -----------------------------------------------------------------------------------------------
Net Income $ 6,260 $ (36) $ - $ 6,224
===============================================================================================
End of Period Securities $144,560 $ 730 $ - $145,290
End of Period Net Loans 371,533 - - 371,533
End of Period Assets 579,482 58,267 (56,113) 581,636
End of Period Deposits 511,714 - (3,434) 508,280
End of Period Borrowings 14,832 1,187 - 16,019
End of Period Liabilities 532,331 7,343 (4,288) 535,386
- -----------------------------------------------------------------------------------------------
(15) FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK
Commitments and Off-Balance Sheet Risk
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.
These financial instruments primarily include commitments to extend credit
and financial guarantees. Such instruments involve, to varying degrees,
elements of credit and interest rate risk that are not recognized in the
accompanying consolidated balance sheets.
Exposure to credit loss in the event of nonperformance by the other party to
the financial instruments for commitments to extend credit and financial
guarantees written is represented by the contractual amount of those
instruments. The Bank uses the same credit policies in making commitments as
it does for on-balance sheet instruments. The contractual amounts of these
financial instruments at December 31, 1998 and 1997 are as follows:
(In thousands) Contractual Amount
--------------------------------------------------------------------
1998
Financial Instruments Whose Contract Amounts
Represent Credit Risk:
Commitments to Extend Credit $105,112
Standby Letters of Credit 5,321
Loans Sold with Recourse 1,106
--------------------------------------------------------------------
(In thousands) Contractual Amount
--------------------------------------------------------------------
1997
Financial Instruments Whose Contract Amounts
Represent Credit Risk:
Commitments to Extend Credit $ 81,762
Standby Letters of Credit 5,650
Loans Sold with Recourse 1,182
--------------------------------------------------------------------
Commitments to extend credit are agreements to lend to a customer as long as
there is no violation of any condition established in the contract.
Commitments generally have fixed expiration dates or other termination
clauses and may require payment of a fee. Since a portion of the commitments
are expected to expire without being drawn upon, the total commitment amount
does not necessarily represent a future cash requirement. The Bank evaluates
each customer's creditworthiness on a case-by-case basis. The amount of
collateral obtained by the Bank upon extension of credit is based on
management's credit evaluation of the counterparty, and an appropriate
amount of real and/or personal property is obtained as collateral.
Standby letters of credit and financial guarantees written are conditional
commitments issued by the Bank to guarantee performance of a customer to a
third party. Those guarantees are primarily issued to support public and
private borrowing arrangements. Most guarantees extend for less than two
years, and approximately 85% are for less than $100 thousand. The credit
risk involved in issuing letters of credit is essentially the same as that
involved in extending loan facilities to customers. The Bank obtains real
and/or personal property as collateral for those commitments for which
collateral is deemed to be necessary.
The Bank may enter into commitments to sell loans, which involve market and
interest rate risk. There were no such commitments at December 31, 1998 or
1997.
Interest Rate Cap and Floor Contracts
Interest rate cap and floor transactions generally involve the exchange of
fixed and floating rate interest payments without the exchange of the
underlying principal amounts. The Company uses floor contracts to mitigate
the effects on net interest income in the event interest rates on floating
rate loans decline and uses cap contracts to mitigate the effects on net
interest income should interest rates on floating rate deposits increase.
The Company is exposed to risk should the counterparty default in its
responsibility to pay interest under the terms of the cap or floor
agreement, but minimizes this risk by performing normal credit reviews on
the counterparties, by limiting its exposure to any one counterparty, and by
utilizing well known national investment firms as counterparties. Notional
principal amounts are a measure of the volume of agreements transacted, but
the level of credit risk is significantly less. At December 31, 1998 and
December 31, 1997, the notional principal amounts of such contracts
outstanding was $80 million and $30 million respectively. At December 31,
1998 and December 31, 1997, the amortized cost of such contracts was $302
thousand and $69 thousand, respectively. $2 thousand was received during
1998 with respect to these contracts.
(16) FAIR VALUE OF FINANCIAL INSTRUMENTS
Investments
The carrying amounts reported in the consolidated balance sheets for cash
and cash equivalents and stock in the Federal Home Loan Bank of Boston
approximate fair values. Fair value for investment securities is determined
from quoted market prices, when available. If quoted market prices are not
available, fair values are based on quoted market prices of comparable
instruments.
An analysis of the fair value of the investment securities as of December
31, 1998 and 1997 is as follows:
1998 1997
-------------------------------------------------------------------------------------
Carrying Carrying
(In thousands) Amount Fair Value Amount Fair Value
-------------------------------------------------------------------------------------
Securities Available for Sale $ 72,205 $ 72,205 $ 44,241 $ 44,241
Securities Held to Maturity 103,851 105,717 111,458 112,467
-------------------------------------------------------------------------------------
$176,056 $177,922 $155,699 $156,708
=====================================================================================
Loans
The fair value of variable rate loans that reprice frequently and have no
significant credit risk is based on carrying values. The fair value for
other loans is estimated using discounted cash flow analyses, using interest
rates currently being offered for loans with similar terms to borrowers of
similar credit quality.
An analysis of the fair value of the loan portfolio as of December 31, 1998
and 1997 is as follows:
1998 1997
----------------------------------------------------------------------
Carrying Carrying
(In thousands) Amount Fair Value Amount Fair Value
----------------------------------------------------------------------
Net Loans $394,192 $400,469 $374,557 $378,093
----------------------------------------------------------------------
Deposits
The fair value of demand deposits approximates the amount reported in the
consolidated balance sheets. The fair value of variable rate, fixed term
certificates of deposit also approximate 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 which
applies interest rates currently being offered for deposits of similar
remaining maturities.
An analysis of the fair value of deposits as of December 31, 1998 and 1997
is as follows:
1998 1997
-------------------------------------------------------------------------------------
Carrying Carrying
(In thousands) Amount Fair Value Amount Fair Value
-------------------------------------------------------------------------------------
Demand Deposits $ 85,998 $ 85,998 $ 76,712 $ 76,712
Savings, NOW and
Money Market 309,897 311,453 267,396 268,380
Time Deposits $100 thousand
and greater 22,746 24,243 23,307 23,540
Other Time Deposits 131,821 131,915 138,429 139,812
-------------------------------------------------------------------------------------
$550,462 $553,609 $505,844 $508,444
=====================================================================================
Debt
The fair value of debt is estimated using current market rates for
borrowings of similar remaining maturity.
An analysis of the fair value of the borrowings of the Company as of
December 31, 1998 and 1997 is as follows:
1998 1997
----------------------------------------------------------------------------
Carrying Carrying
(In thousands) Amount Fair Value Amount Fair Value
----------------------------------------------------------------------------
Other Borrowed Funds $9,283 $9,283 $8,000 $8,000
----------------------------------------------------------------------------
Debt 6,409 6,731 6,415 6,645
----------------------------------------------------------------------------
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 $53 thousand and $65 thousand as of December 31, 1998 and 1997,
respectively.
Interest Rate Caps and Floors
The fair value of the interest rate caps and floors associated with variable
rate commercial loans approximates the book carrying value. Management bases
estimates on quotes, from qualified investment brokers, of the market value
of the cap or floor at the reporting date. The fair value of the interest
rate cap and floor contracts at December 31, 1998 was $280 thousand, the
amortized cost was $302 thousand.
(17) SUMMARY OF UNAUDITED FINANCIAL INFORMATION:
(In thousands except per share data) 1998 1997
- --------------------------------------------------------------------------------------------------------------------------------
Q4 Q3 Q2 Q1 Year Q4 Q3 Q2 Q1 Year
- --------------------------------------------------------------------------------------------------------------------------------
Interest and Fee
Income $12,006 $11,969 $12,154 $11,894 $48,023 $12,120 $12,137 $12,017 $11,884 $48,158
Interest Expense 4,629 4,687 4,663 4,551 18,530 4,616 4,578 4,576 4,468 18,238
- --------------------------------------------------------------------------------------------------------------------------------
Net Interest Income 7,377 7,282 7,491 7,343 29,493 7,504 7,559 7,441 7,416 29,920
Provision for Possible
Loan Losses(1)(2) (1,618) - (119) - (1,737) (2,162) - - 300 (1,862)
Noninterest Income(3) 1,809 1,770 1,976 1,757 7,312 2,700 1,740 1,715 1,761 7,916
Noninterest Expense(4) 6,957 5,931 6,489 6,095 25,472 9,057 6,445 6,468 6,512 28,482
- --------------------------------------------------------------------------------------------------------------------------------
Income Before Provision
for Income Taxes 3,847 3,121 3,097 3,005 13,070 3,309 2,854 2,688 2,365 11,216
Provision For Income
Taxes 911 789 789 759 3,248 607 665 610 501 2,383
- --------------------------------------------------------------------------------------------------------------------------------
Net Income $ 2,936 $ 2,332 $ 2,308 $ 2,246 $ 9,822 $ 2,702 $ 2,189 $ 2,078 $ 1,864 $ 8,833
================================================================================================================================
Basic Earnings Per
Share $ 0.66 $ 0.53 $ 0.52 $ 0.51 $ 2.22 $ 0.61 $ 0.50 $ 0.47 $ 0.42 $ 2.00
================================================================================================================================
Cash Dividends
Declared Per Share $ 0.19 $ 0.18 $ 0.17 $ 0.17 $ 0.71 $ 0.15 $ 0.15 $ 0.10 $ 0.10 $ 0.50
================================================================================================================================
<FN>
- --------------------
<F1> During the fourth quarter of 1998, the Bank reduced its reserve for
possible loan losses by approximately $1.6 million. The reduction is
primarily a result of management's determination that a lower
requirement was appropriate due to a changing mix of the loan
portfolio, the impact of conservative underwriting standards
implemented in previous periods and the favorable resolution of a
significant troubled credit.
<F2> During the fourth quarter of 1997 the Bank recognized recoveries on
two previously charged off loans of approximately $2.2 million. This
amount was credited to income through the provision for loan losses.
<F3> During the fourth quarter of 1997 the Bank recognized a gain of $840
on a security it held with a zero basis.
<F4> During the fourth quarter of 1997 the Bank recognized losses resulting
from its conversion to the Windows NT platform totaling $590 thousand;
the Bank incurred or accrued legal and professional expenses in
conjunction with a lawsuit brought by a former customer totaling $1.2
million; the Bank made a one-time contribution to the Merchants Bank
Foundation of $400 thousand; and a $478 thousand write-down was taken
against one of the Bank's branch properties, based on the decision to
sell the property.
</FN>
(18) REGULATORY ENVIRONMENT
The Bank and the Company are subject to various regulatory capital
requirements administered by federal banking agencies. Failure to meet
minimum capital requirements can initiate certain mandatory, and possible
additional discretionary, actions by regulators that, if undertaken, could
have a direct material effect on the Bank's and the Company's financial
statements. Under capital adequacy guidelines, the Bank and the Company must
meet specific capital guidelines that involve quantitative measures of the
Bank's and the Company's assets, liabilities, and certain off-balance-sheet
items as calculated under regulatory accounting practices. The Bank is also
subject to the regulatory framework for prompt corrective action that
requires the Bank to meet specific capital guidelines to be considered well
capitalized. The Bank's and the Company's 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 the Bank and the Company 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 December 31, 1998,
that the Bank and the Company meet all capital adequacy requirements to
which it is subject.
As of December 31, 1998, the most recent notification from the FDIC
categorized the 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 the institution's
category. To be considered well capitalized under the regulatory framework
for prompt corrective action, the Bank must maintain minimum Tier-1
Leverage, Tier-1 Risk-Based, and Total Risk-Based Capital ratios as set
forth in the table below.
To Be Well-
Capitalized Under
For Capital Prompt Corrective
(In thousands) Actual Adequacy Purposes Action Provisions
- ---------------------------------------------------------------------------------------------------
Amount Percent Amount Percent Amount Percent
- ---------------------------------------------------------------------------------------------------
As of December 31, 1998:
Merchants Bancshares, Inc.:
Tier 1 Risk-Based Capital $58,677 14.45% $16,248 4.00% N/A
Total Risk-Based Capital 63,747 15.69% 32,591 8.00% N/A
Tier 1 Leverage Capital 58,677 9.49% 24,828 4.00% N/A
Merchants Bank:
Tier 1 Risk-Based Capital $58,582 14.38% $16,295 4.00% $37,242 6.00%
Total Risk-Based Capital 63,652 15.62% 32,591 8.00% 40,738 10.00%
Tier 1 Leverage Capital 58,582 9.45% 24,876 4.00% 31,096 5.00%
- ---------------------------------------------------------------------------------------------------
As of December 31, 1997:
Merchants Bancshares, Inc.:
Tier 1 Risk-Based Capital $50,596 12.49% $16,210 4.00% N/A
Total Risk-Based Capital 55,806 13.78% 32,401 8.00% N/A
Tier 1 Leverage Capital 50,596 8.70% 23,313 4.00% N/A
Merchants Bank:
Tier 1 Risk-Based Capital $52,536 12.94% $16,246 4.00% $24,369 6.00%
Total Risk-Based Capital 57,746 14.22% 32,491 8.00% 40,614 10.00%
Tier 1 Leverage Capital 52,536 9.01% 23,313 4.00% 29,141 5.00%
- ---------------------------------------------------------------------------------------------------
Merchants Bancshares, Inc. and Subsidiaries
Interest Management Analysis
(In thousands, taxable equivalent) 1998 1997 1996
- ----------------------------------------------------------------------------------------------------------------
Interest % of Interest % of Interest % of
Income/ Average Income/ Average Income/ Average
Expense Assets Expense Assets Expense Assets
- ----------------------------------------------------------------------------------------------------------------
NET INTEREST INCOME:
Total Interest Income, Including
Fees on Loans $ 48,098 7.97% $ 48,254 8.35% $ 48,140 8.29%
Interest Expense 18,530 3.07 18,238 3.15 18,672 3.21
- ----------------------------------------------------------------------------------------------------------------
Net Interest Income Before Provision for
Possible Loan Losses 29,568 4.90 30,016 5.20 29,468 5.08
Provision for Possible Loan Losses (1,737) -0.29 (1,862) -0.32 3,150 0.54
- ----------------------------------------------------------------------------------------------------------------
Net Interest Income $ 31,305 5.19% $ 31,878 5.52% $ 26,318 4.54%
================================================================================================================
OPERATING EXPENSE ANALYSIS:
Noninterest Expense
Personnel $ 11,470 1.90% $ 10,674 1.85% $ 10,013 1.72%
Occupancy and Equipments Expense 4,567 0.76 4,496 0.78 4,078 0.70
Legal and Professional Fees 2,447 0.41 3,888 0.67 1,961 0.34
Loss / (Gain) on Disposition of Fixed
Assets 127 0.02 1,088 0.19 (565) -0.10
Other 6,861 1.14 8,336 1.44 12,002 2.07
- ----------------------------------------------------------------------------------------------------------------
Total Noninterest Expense 25,472 4.22 28,482 4.93 27,489 4.73
- ----------------------------------------------------------------------------------------------------------------
Less Noninterest Income
Service Charges on Deposits 2,756 0.46 3,075 0.53 3,347 0.58
Other, Including Securities Gains 4,556 0.76 4,841 0.84 6,016 1.04
- ----------------------------------------------------------------------------------------------------------------
Total Noninterest Income 7,312 1.22 7,916 1.37 9,363 1.62
- ----------------------------------------------------------------------------------------------------------------
Net Operating Expense $ 18,160 3.00% $ 20,566 3.56% $ 18,126 3.11%
================================================================================================================
SUMMARY:
Net Interest Income $ 31,305 5.19% $ 31,878 5.52% $ 26,318 4.54%
Less: Net Operating Expense 18,160 3.00 20,566 3.56 18,126 3.11
- ----------------------------------------------------------------------------------------------------------------
Profit Before Taxes-
Taxable Equivalent Basis 13,145 2.19 11,312 1.96 8,192 1.43
Net Profit (Loss) After Taxes $ 9,822 1.63% $ 8,833 1.53% $ 6,224 1.07%
- ----------------------------------------------------------------------------------------------------------------
TOTAL AVERAGE ASSETS $603,312 $578,090 $580,860
================================================================================================================
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Except for the historical information contained herein, this Annual Report
on Form 10-K may contain forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934. Investors 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,
including, without limitation, (i) the fact that the Company's success is
dependent to a significant extent upon general economic conditions in
Vermont and Vermont's ability to attract new business, (ii) the fact that
the Company's earnings depend to a great extent upon the level of net
interest income (the difference between interest income earned on loans and
investments and the interest expense paid on deposits and other borrowings)
generated by the Bank, and the level of net interest income and thus the
Bank's results of operations may be adversely affected by increases or
decreases in interest rates, and (iii) the fact that the banking business is
highly competitive and the profitability of the Company depends upon the
Bank's ability to attract loans and deposits in Vermont, where the Bank
competes with a variety of traditional banking and nontraditional
institutions such as credit unions and finance companies, and (iv) the fact
that at December 31, 1998, the Company's balance sheet loan portfolio was
$405 million of which commercial loans represented 52.2%, exposing the
Company to the risks inherent in financings based upon analyses of credit
risk, the value of underlying collateral, including real estate, and other
more intangible factors which are considered in making commercial loans.
Accordingly, the Company's profitability may be negatively impacted by
errors in risk analyses and by loan defaults and the ability of certain
borrowers to repay such loans may be adversely affected by any downturn in
general economic conditions. Additional risks and uncertainties are inherent
in the Year 2000 project. The costs of the Year 2000 conversion, the date
which the Company has set to complete its Year 2000 project and statements
about anticipated compliance are based on the Company's current estimates
and are subject to various uncertainties that could cause actual results to
differ materially from the Company's expectations. Such uncertainties
include, among others, the success of the Company in identifying systems
that are not Year 2000 compliant, the nature and amount of programming
required to upgrade or replace each of the affected systems, the
availability of qualified personnel, consultants and other resources, and
the success of the Year 2000 compliance efforts of others. These factors, as
well as general economic and market conditions, may materially and adversely
affect the market price of the Company's common shares. Because of these and
other factors, past financial performance should not be considered an
indicator of future performance. The forward-looking statements contained
herein represent the Company's judgment as of the date of this Form 10-K,
and the Company cautions readers not to place undue reliance on such
statements.
The following discussion and analysis of financial condition and results of
operations of the Company and its subsidiaries for the three years ended
December 31, 1998 should be read in conjunction with the consolidated
financial statements and notes thereto and selected statistical information
appearing elsewhere in this Annual Report on Form 10-K. The information is
discussed on a fully taxable equivalent basis. The financial condition and
operating results of the Company essentially reflect the operations of its
principal subsidiary, Merchants Bank.
RESULTS OF OPERATIONS: OVERVIEW
The Company recognized net income of $9.8 million for the year ended
December 31, 1998, an increase of $1.0 million from 1997. The one-time
charges and credits that influenced 1998 earnings included a $1.6 million
negative provision for possible loan losses during the fourth quarter of
1998. For a more detailed discussion of the Bank's reserve for possible loan
losses see "Credit Quality and Reserve for Possible Loan Losses".
Conversely, the Company incurred legal and professional expenses in
conjunction with a lawsuit brought by a former customer totaling $845
thousand during 1998 (See "Noninterest Income and Expenses"). An additional
event affecting overall earnings during 1998 was an unscheduled contribution
of $150 thousand to the Merchants Bank Foundation, a charitable organization
created during the 1980s to promote community activities in Vermont.
Basic earnings per share were $2.22, $2.00 and $1.45 for the years ended
December 31, 1998, 1997 and 1996, respectively. Diluted earnings per share
were $2.21, $1.99 and $1.45 for the years ended December 31, 1998, 1997 and
1996, respectively. The Company declared and distributed a total of $.71 per
share during 1998. In January 1999, the Company declared a dividend of $0.19
per share.
Net income as a percentage of average equity capital was 17.46%, 17.98%, and
14.44% for 1998, 1997 and 1996, respectively. The ten-year average return on
equity is 7.78% at December 31, 1998. Net income as a percentage of average
assets was 1.63%, 1.53%, and 1.07% in 1998, 1997 and 1996, respectively. The
ten-year average return on assets is .60% at December 31, 1998.
NET INTEREST INCOME
Net interest income before the provision for possible loan losses is the
difference between total interest, loan fees and investment income, and
total interest expense. Total interest and dividend income decreased $135
thousand from 1997 to 1998 (.3%) and total interest expense increased by
$292 thousand (1.6%), resulting in a decrease in net interest income of $427
thousand (1.4%). The overall decrease in net interest income, and resultant
decrease in net interest margin is attributable to several factors. One of
these is the flat yield curve and lower interest rate environment that was
prevalent during 1998. Many of the Bank's longer term assets are funded with
short term, or variable rate, liabilities. As the yield curve flattened over
the course of 1998 loan and investment rates dropped more quickly than
deposit rates. Overall average earning assets increased by $25.3 million
(4.6%) from $541 million to $566 million during 1998, but the average rate
earned on those assets decreased by 42 basis points from 8.92% to 8.50%.
Changes in the mix of earning assets account for a portion of this change.
Average investments, which generally have a lower yield than loans, grew by
$23.7 million during 1998. Average loans decreased by $2.6 million during
1998, and the loan mix changed as the Bank continued its strategy to move
higher risk commercial real estate loans off the balance sheet. At the same
time, average interest bearing liabilities increased by $11.7 million from
$446 million to $457 million (2.6%), while the average rate on those
liabilities decreased by only 4 basis points, from 4.09% to 4.05%. The
following table presents the condensed annual average balance sheets for
1998, 1997 and 1996. The total dollar amount of interest income from assets
and the subsequent yields are calculated on a taxable equivalent basis.
Merchants Bancshares, Inc.
Distribution of Assets, Liabilities and Stockholders' Equity;
Interest Rates and Interest Differential
1998 1997 1996
- ---------------------------------------------------------------------------------------------------------------------------------
Taxable Equivalent Interest Average Interest Average Interest Average
(In thousands) Average Income/ Yield/ Average Income/ Yield/ Average Income/ Yield/
ASSETS: Balance Expense Rate Balance Expense Rate Balance Expense Rate
- ---------------------------------------------------------------------------------------------------------------------------------
Investment Securities:
U.S. Treasury and Agencies $165,071 $10,728 6.50% $142,070 $ 9,443 6.65% $117,908 $ 7,588 6.44%
Other, Including FHLB Stock 3,098 161 5.20% 2,435 172 7.06% 2,865 148 5.17%
- ---------------------------------------------------------------------------------------------------------------------------------
Total Investment Securities 168,169 10,889 6.48% 144,505 9,615 6.65% 120,773 7,736 6.41%
- ---------------------------------------------------------------------------------------------------------------------------------
Loans, Including Fees on Loans:
Commercial 67,609 7,017 10.38% 68,036 7,479 10.99% 68,783 7,281 10.59%
Real Estate 309,534 28,095 9.08% 311,490 29,286 9.40% 322,690 31,135 9.65%
Consumer 14,671 1,759 11.99% 14,763 1,763 11.94% 15,041 1,673 11.12%
- ---------------------------------------------------------------------------------------------------------------------------------
Total Loans(a)(b) 391,814 36,871 9.41% 394,289 38,528 9.77% 406,514 40,089 9.86%
- ---------------------------------------------------------------------------------------------------------------------------------
Federal Funds Sold, Securities Sold
Under Agreements to Repurchase
and Interest Bearing Deposits
with Banks 6,143 338 5.50% 2,036 111 5.45% 5,905 315 5.33%
- ---------------------------------------------------------------------------------------------------------------------------------
Total Earning Assets 566,126 48,098 8.50% 540,830 48,254 8.92% 533,192 48,140 9.03%
- ---------------------------------------------------------------------------------------------------------------------------------
Reserve for Possible Loan Losses (14,790) (16,267) (15,983)
Cash and Due From Banks 21,115 22,833 28,907
Premises and Equipment 13,358 14,513 13,298
Other Assets 17,503 16,182 21,446
- ---------------------------------------------------------------------------------------------------------------------------------
Total Assets $603,312 $578,090 $580,860
=================================================================================================================================
LIABILITIES AND STOCKHOLDERS' EQUITY:
Interest Bearing Deposits:
Savings, Money Market & NOW
Accounts $285,489 $ 9,175 3.21% $265,578 $ 8,452 3.18% $264,611 $ 8,217 3.11%
Time Deposits 159,430 8,573 5.38% 164,437 8,864 5.39% 170,439 9,508 5.58%
- ---------------------------------------------------------------------------------------------------------------------------------
Total Interest Bearing
Deposits 444,919 17,748 3.99% 430,015 17,316 4.03% 435,050 17,725 4.07%
- ---------------------------------------------------------------------------------------------------------------------------------
Federal Funds Purchased 730 42 5.75% 906 54 5.96% 703 32 4.59%
Demand Notes Due U.S. Treasury 1,939 100 5.16% 2,463 130 5.28% 2,134 108 5.04%
Other Short-Term Borrowings 2,986 170 5.69% 5,925 307 5.18% 4,206 205 4.88%
Long-Term Debt 6,890 470 6.82% 6,417 431 6.72% 8,925 602 6.75%
- ---------------------------------------------------------------------------------------------------------------------------------
Total Interest Bearing
Liabilities 457,464 18,530 4.05% 445,726 18,238 4.09% 451,019 18,672 4.14%
- ---------------------------------------------------------------------------------------------------------------------------------
Demand Deposits 80,541 75,972 78,873
Other Liabilities 9,064 7,252 7,857
Stockholders' Equity 56,243 49,140 43,111
- ---------------------------------------------------------------------------------------------------------------------------------
Total Liabilities &
Stockholders' Equity $603,312 $578,090 $580,860
=================================================================================================================================
Net Interest Income(a) $29,568 $30,016 $29,468
=================================================================================================================================
Yield Spread 4.45% 4.83% 4.89%
=================================================================================================================================
NET INTEREST INCOME
TO EARNING ASSETS 5.22% 5.55% 5.53%
=================================================================================================================================
<FN>
- --------------------
<Fa> Tax exempt interest has been converted to a tax equivalent basis using
the Federal tax rate of 34%.
<Fb> Includes nonaccruing loans.
</FN>
The following table sets forth, for each major category of interest earning
assets and interest bearing liabilities, the dollar amounts of fully taxable
equivalent interest income and interest expense and changes therein for 1998
as compared with 1997.
Merchants Bancshares, Inc.
Analysis of Changes in Fully Taxable Equivalent Net Interest Income
1998 vs 1997
- -------------------------------------------------------------------------------------------------------------
Due to(a)
Increase --------------------
(In thousands) 1998 1997 (Decrease) Volume Rate
- -------------------------------------------------------------------------------------------------------------
Fully Taxable Equivalent Interest Income:
Loans(b) $36,871 $38,528 $(1,657) $ (233) $(1,424)
Investments 10,889 9,615 1,274 1,532 (258)
Federal Funds Sold, Securities Sold Under
Agreements to Repurchase and Interest
Bearing Deposits with Banks 338 111 227 226 1
- -------------------------------------------------------------------------------------------------------------
Total Interest Income 48,098 48,254 (156) 1,525 (1,681)
- -------------------------------------------------------------------------------------------------------------
Less Interest Expense:
Savings, Money Market & NOW
Accounts 9,175 8,452 723 640 83
Time Deposits 8,573 8,864 (291) (269) (22)
Federal Funds Purchased 42 54 (12) (10) (2)
Demand Note-U.S. Treasury 100 130 (30) (27) (3)
Debt and Other Borrowings 640 738 (98) (135) 37
- -------------------------------------------------------------------------------------------------------------
Total Interest Expense 18,530 18,238 292 198 94
- -------------------------------------------------------------------------------------------------------------
Net Interest Income $29,568 $30,016 $ (448) $1,327 $(1,775)
=============================================================================================================
1997 vs 1996
- -------------------------------------------------------------------------------------------------------------
Due to(a)
Increase --------------------
(In thousands) 1997 1996 (Decrease) Volume Rate
- -------------------------------------------------------------------------------------------------------------
Fully Taxable Equivalent Interest Income:
Loans(b) $38,528 $40,089 $(1,561) $ 0 $(1,561)
Investments 9,615 7,736 1,879 (30) 1,909
Federal Funds Sold, Securities Sold Under
Agreements to Repurchase and Interest
Bearing Deposits with Banks 111 315 (204) - (204)
- -------------------------------------------------------------------------------------------------------------
Total Interest Income 48,254 48,140 114 (30) 144
- -------------------------------------------------------------------------------------------------------------
Less Interest Expense:
Savings, Money Market & NOW
Accounts 8,452 8,217 235 - 235
Time Deposits 8,864 9,508 644 18 662
Federal Funds Purchased 54 32 22 - 22
Demand Note-U.S. Treasury 130 108 22 12 10
Debt and Other Borrowings 738 807 (69) 106 (175)
- -------------------------------------------------------------------------------------------------------------
Total Interest Expense 18,238 18,672 (434) 136 (570)
- -------------------------------------------------------------------------------------------------------------
Net Interest Income $30,016 $29,468 $ 548 $ (167) $ 715
=============================================================================================================
<FN>
- --------------------
<Fa> The dollar amount of changes in interest income and interest expense
attributable to changes in rate and volume has been allocated between
rate and volume based upon the changes in rates times the first
year's volume and the changes in volume times the current year's
rate.
<Fb> Includes balances of non-accruing loans.
<FNote:> Included in Interest Income are fees on loans totaling $1,570, $1,619
and $2,333 for the years ended December 31, 1998, 1997 and 1996,
respectively
</FN>
The Bank's fees on loans continued to decrease in 1998, decreasing $50
thousand from 1997 to 1998. This decrease is due primarily to a strategic
decision made by the Bank's Asset/Liability Committee in 1996 to hold many
of its originated mortgages in portfolio rather than sell them in the
secondary market. The Bank has historically had a disproportionately low
allocation of residential real estate mortgages in its portfolio. Management
believes the retention of these credits in portfolio, while decreasing
servicing revenue, will result in higher interest revenue than could be
earned in the Bank's investment portfolio.
From 1996 to 1997, total interest and dividend income increased $154
thousand (0.3%) and total interest expense decreased $434 thousand (2.32%).
This resulted in an increase to net interest income before provision for
possible loan losses of $588 thousand (1.97%) from $29.3 million in 1996 to
$29.9 million in 1997. A number of factors contributed to these changes.
First, the Company's portfolio of nonperforming loans continued to decrease,
from $6.7 million at year-end 1996 to $3.3 million at year-end 1997, and the
Company's other real estate owned (OREO) portfolio decreased by $1.3 million
from $1.9 million at year-end 1996 to $591 thousand at year-end 1997.
Second, the Bank's overall loan portfolio increased by $3.2 million (0.8%),
while the Bank's investment portfolio increased by $11.4 million (7.87%).
Finally, deposits decreased by $2.5 million from year-end 1996 to year-end
1997 (see "Balance Sheet Analysis" for a more comprehensive discussion of
changes in the balance sheet). The yield on total interest earning assets
decreased from 9.03% for the year 1996 to 8.92% for the year 1997, as a
result of the change in the composition of interest earning assets discussed
above, and increased competition from both bank and non-bank competitors.
The cost of interest bearing liabilities decreased slightly from 4.14% for
the year 1996 to 4.09% for the year 1997. This decrease in cost results from
the Bank's continuing strategies to encourage the movement of balances from
time deposits to money market accounts and NOW accounts. The Bank's
FreedomLYNX(r) accounts increased by $7.3 million over the course of 1997,
at an average cost of funds of 1.76%. The combination of the changes
discussed above led to a small increase in the overall net interest margin
from 5.53% for the year 1996 to 5.55% for the year 1997.
RESERVE FOR POSSIBLE LOAN LOSSES
In the fourth quarter of 1998, the Bank recorded a $1.6 million credit
provision for possible loan losses resulting in an overall credit provision
of $1.7 million in 1998. This reduction of the loan loss reserve was
primarily the result of an internal review of the Bank's loan loss reserve
requirement, which considered the changing mix and improved quality of the
loan portfolio, the impact of conservative underwriting standards
implemented in previous periods, general economic conditions, and the
resolution of a significant troubled credit. The Bank's analysis has been
substantiated by a comprehensive assessment of its loan portfolio and review
of its loan loss reserve requirement by its external loan review firm during
the fourth quarter of 1998. For a more detailed discussion of the Bank's
reserve for possible loan losses see "Credit Quality and Reserve for
Possible Loan Losses".
NONINTEREST INCOME AND EXPENSES
Excluding net gains on the sale of investment securities of $44 thousand in
1998 and $784 thousand in 1997 noninterest income increased $136 thousand
(1.9%) from 1997 to 1998. The increase was primarily the result of increases
in Trust Company income of $275 thousand, a 16.8% increase. Service charges
on deposits decreased $319 thousand during 1998, a 10.4% decrease. The
decrease in service charge revenue is primarily a result of the Bank's
continued FreedomLYNX(r) sales campaign. These accounts currently charge no
fees to customers who have a direct deposit, a debit card or an automatic
loan payment. For a limited time beginning in February 1999, as part of the
Bank's 150th birthday celebration, the Bank will drop all electronic
qualifications for the FreedomLYNX(r) account and offer the account free for
life. Although there are generally no fees on these accounts, the average
interest cost at December 31, 1998 was approximately 1.52% and the average
balance maintained by the customer is higher than a regular checking
account. This account is representative of a strategic decision made by the
Bank to deemphasize fee income in favor of collecting low interest checking
account balances which will increase margin income over time, and also
encourage customers to maximize use of the Bank's technology. Fees on
merchants discounts on credit cards decreased by $93 thousand (6.1%) during
1998, primarily a result of continuing decline in transaction volumes. Other
noninterest income increased by $273 thousand during 1998, primarily due to
the recognition of gains on the sales of certain loans of $213 thousand (see
Balance Sheet Analysis).
Excluding the FDIC assistance received pursuant to the loss sharing
agreement (since terminated) of $407 thousand during 1996, noninterest
income decreased $1 million (11.6%) from 1996 to 1997. There were three one-
time events in the two years that effected this change. First, during 1997,
the Bank recognized an $840 thousand gain on an investment it had with a
zero basis. Second, during 1996, the Bank recognized a net gain on the sale
of a bank branch of $300 thousand, and third, during 1996, the Bank received
refunds of Vermont Franchise Tax paid in prior years of $885 thousand. Trust
Company revenue increased $142 thousand (9.51%) in 1997 over 1996; the
result of increased marketing efforts by the Trust Company. Service charges
on deposits decreased $272 thousand from 1996 to 1997 as the Bank continued
to increase FreedomLYNX(r) account balances. Fees received related to
merchants discounts on credit cards decreased by $159 thousand as a result
of lower transaction volumes during 1997.
Noninterest expenses decreased $3.0 million (10.1%) from 1997 to 1998. A
significant contributing factor being a decrease of $1.5 million (37%) in
legal and professional fees, from $3.9 million for the year ended December
31, 1997 to $2.4 million for the year ended December 31, 1998. This decrease
was due primarily to a decrease in expenses incurred by the Bank as it
defended itself in litigation entitled "Pasquale and Vatsala Vescio,
counterclaim Plaintiffs v. The Merchants Bank, Counterclaim Defendant", now
pending in the United States Bankruptcy Court for the District of Vermont.
For further information on this litigation see Part I, Item 3, Legal
Proceedings. Losses on the disposition of fixed assets also decreased during
1998. The $961 thousand (88%) decrease was primarily a result of $400
thousand in expenses recognized during 1997 related to the Company's
conversion to the Windows NT platform. Additionally, during 1997, the Bank
wrote down the basis of its branch in Brattleboro, VT by $478 thousand in
conjunction with the sale of the building. Substantially all of the 1998
expense is related to the Bank's conversion of its teller system to the
Windows NT platform during 1998. This change will enable our front line
personnel to perform a multitude of tasks and access extensive customer
information without leaving their stations, increasing efficiencies and
improving overall customer service. Recognizing that technology changes
almost daily in the current environment, the Company has made the decision
to depreciate current investments in technology based fixed assets and
related software over a three year schedule. Salaries and wages increased by
$752 thousand (8.7%) from 1997 to 1998. This increase is primarily
attributable to the Company's incentive program. This program is designed to
compensate employees based on their individual performance, as well as the
performance of their divisions. The program for 1998 focused on improved
efficiency and profitability for employees in the service center, and on
increased growth and sales in the branches and sales division. Other
noninterest expenses decreased by $895 thousand during 1998, primarily the
result of a decrease in the contribution made to the Merchants Bank
Foundation during 1998, from $400 thousand during 1997 to $150 thousand
during 1998. Finally, during 1997, an investment held by a subsidiary of the
Bank was written down by $229 thousand.
Noninterest expenses increased $1.4 million (5.17%) in 1997 from 1996,
excluding losses and write-downs on Segregated Assets reimbursed by the
FDIC. There were several significant nonrecurring events contributing to
this increase. The first such expense was the expense recognized in
conjunction with the Company's conversion to the Windows NT platform. The
significant expenses recognized in conjunction with this conversion were
$395 thousand in costs associated with project management and training, and
$400 thousand recognized in conjunction with the retirement of certain not
yet fully depreciated assets. The second significant expense during 1997 was
a $478 thousand write-down of the Bank's branch in Brattleboro VT when the
Bank made the decision to sell the property and lease back the portion used
for a branch office. A third expense recognized during 1997 was a $400
thousand contribution to the Merchants Bank Foundation, a charitable
organization established in the 1980s to support community activities in
Vermont.
Another significant factor which contributed to the overall increase in
noninterest expenses during 1997 was an increase of $2 million in legal and
professional fees, from $1.5 million for the year ended December 31, 1996 to
$3.5 million for the year ended December 31, 1997. The increase was due
primarily to expenses incurred by the Bank as it defended itself in
litigation entitled "Pasquale and Vatsala Vescio, counterclaim Plaintiffs v.
The Merchants Bank, Counterclaim Defendant", now pending in the United
States Bankruptcy Court for the District of Vermont. For further information
on this litigation see Part I, Item 3, Legal Proceedings. The Bank saw a
substantial decrease in its expenses associated with Other Real Estate Owned
(OREO), from $3.4 million in 1996 to $314 thousand in 1997 (90.8%). The
decrease was a direct result of the decrease in the OREO portfolio from $1.9
million at year-end 1996 to $591 thousand at year-end 1997. Salaries and
Wages, and associated benefits increased from $10 million for the year 1996
to $10.7 million for the year 1997 (6.7%). This increase was primarily
attributable to the Company's incentive program begun in 1996.
The Company recognized $1,328 thousand in low-income housing tax credits as
a reduction in the provision for income taxes during 1998 and $1,089
thousand during 1997. As of December 31, 1998, the Company has a cumulative
deferred prepaid tax asset of approximately $4.3 million arising from timing
differences between the Company's book and tax reporting. The prepaid tax
asset is included in other assets.
BALANCE SHEET ANALYSIS
The Company's overall balance sheet grew by $51 million (8.7%) during 1998,
while the Company's earning assets increased by $37.6 million (6.7%) from
$548.4 million to $586 million. The investment portfolio grew by $20.4
million (13%), and the loan portfolio increased by $15.1 million (3.9%). The
increase in the loan portfolio is net of sales of primarily commercial real
estate loans with an aggregate book value of $15.1 million, the Bank
recognized a recovery of $119 thousand and a gain of $238 thousand in
conjunction with the loan sales. The changes in the composition of the
Bank's loan portfolio during 1998 are shown in the following table:
As of December 31,
Type of Loan 1998 1997 1996 1995 1994
- -----------------------------------------------------------------------------------------------
(In thousands)
Commercial, Financial &
Agricultural $ 63,953 $ 73,523 $ 61,091 $ 76,925 $ 92,612
Real Estate-Construction 8,091 8,695 3,420 9,644 21,992
Real Estate-Commercial 170,892 181,018 203,022 225,884 235,104
Real Estate-Residential 147,348 111,270 104,355 120,318 142,325
Installment 14,676 15,450 14,831 16,560 18,086
Lease Financing - - - - -
All Other Loan 532 432 534 393 436
- -----------------------------------------------------------------------------------------------
$405,492 $390,388 $387,233 $449,724 $510,555
===============================================================================================
Residential real estate loans increased by $36.1 million. The Bank
introduced its new RealLYNX(tm) residential real estate loan product during
the first quarter of 1998. This product shortens the turnaround time on
residential mortgages by requiring reduced documentation from borrowers. The
introduction of this product coupled with the high volume of refinancing of
home mortgages during the low interest rate environment that was prevalent
during much of 1998 helped to fuel much of the growth in the residential
real estate portfolio. The Bank closed a total of 783 one-to-four family
residential mortgage loans totaling $59.8 million during 1998; a significant
increase from the 366 loans totaling $26.7 million that closed during 1997.
Substantially all of the originations in the last two years were placed in
the Bank's portfolio as the Bank currently does not sell home mortgages on
the secondary market. The Bank currently services $132.0 million in
residential mortgage loans for other investors such as federal government
agencies (FNMA and FHLMC) and for financial investors such as insurance
companies and pension funds located outside Vermont.
Commercial mortgages decreased by $10.1 million during 1998. This change
reflects the Bank's continuing strategy to deemphasize higher risk
commercial real estate loans as it more actively pursues small business and
commercial credits, as well as residential real estate loans. During 1998,
the Bank remained an active participant in the U.S. Small Business
Administration guaranteed loan program. 18 new SBA loans totaling $3.5
million were originated during 1998 with SBA guarantees ranging from 60% to
90%. This volume of new lending activity represents a 3% increase from that
experienced in 1997. Substantially all of the SBA loans originated in 1998
have remained in portfolio. SBA guarantees are advantageous to the Bank
because they reduce risk in the Bank's loan portfolio and allow the Bank to
increase its commercial loan base and market share with minimal impact on
capital. In 1998, the Bank's ALCO continued the strategy of holding most of
its originated loans in portfolio instead of selling them on the secondary
market. During 1998, the Bank originated 582 commercial and commercial real
estate loans, throughout Vermont, totaling $98.2 million. This lending
activity represented an increase of approximately 32% of new loan volume
from that experienced in 1997. This significant increase was offset in part
by amortization of the existing portfolio and the previously discussed loan
sale. The sale of these performing assets was a continuation of the Bank's
strategy to reduce the proportion of higher commercial real estate loans
held in its portfolio.
The following table presents the distribution of the varying maturities or
repricing opportunities of the loan portfolio at December 31, 1998.
Over One
One Year Through Over Five
Type of Loan Or Less 5 Years Years Total
------------------------------------------------------------------------------------
(In thousands)
Commercial Loans, Industrial
Revenue Bonds, Lease Financing
and All Other Loans $ 39,059 $ 12,664 $ 12,763 $ 64,486
Real Estate Loans 99,631 118,713 107,986 326,330
Installment Loans 3,057 4,864 6,755 14,676
------------------------------------------------------------------------------------
$141,747 $136,241 $127,504 $405,492
====================================================================================
Loans maturing or repricing after one year which have predetermined interest
rates totaled $262.9 million. Loans maturing or repricing after one year
which have floating or adjustable interest rates totaled $1.1 million.
The Company's interest bearing liabilities increased by $36.5 million (8.2%)
from $453.5 million to $480 million during 1998. This change is primarily a
result of an increase in the Company's Savings, NOW and Money Market
Accounts from $267 million at year end 1997 to $310 million at year end
1998. During the third quarter of the year the Bank introduced its new
MoneyLYNX(tm) and CommerceLYNX(tm) money market accounts. The balances pay
interest at competitive rates based on a tiered balance structure. The
average cost of funds on these new balances at December 31, 1998 was 4.3%.
Balances in these accounts totaled $51 million at year end 1998. Balances in
the Bank's FreedomLYNX(r) accounts continue to increase, with balances of
$19.8 million at December 31, 1998 versus $10.4 million at December 31,
1997. The FreedomLYNX(r) account bears interest at a slight premium to the
NOW rate on balances over $1,500 and requires no minimum balance, the
average cost of these funds at year end was 1.52%. The Bank's year end
demand deposit balances increased by $9.3 million during 1998, a result of
the overall larger customer base.
The following schedule shows the average balances of various classifications
of deposits:
(In thousands) 1998 1997 1996
-----------------------------------------------------------------
Demand Deposits $ 80,541 $ 75,972 $ 78,873
Savings, Money Market and
Now Accounts 285,489 265,578 264,611
Time Deposits $100,000 and
Greater 24,130 19,750 20,059
Other Time Deposits 135,300 144,687 150,380
-----------------------------------------------------------------
Total Average Deposits $525,460 $505,987 $513,923
=================================================================
Time Deposits $100 thousand and greater at December 31, 1998 had the
following schedule of maturities:
(In thousands)
----------------------------------------
Three Months or Less $ 5,452
Three to Six Months 3,829
Six to Twelve Months 4,679
Over Twelve Months 2,113
Over Five Years 6,673
----------------------------------------
$22,746
========================================
CREDIT QUALITY AND RESERVE FOR POSSIBLE LOAN LOSSES
Improving credit quality has been a major strategic focus of the Bank since
1994. The success of this program is evidenced by the Bank's aggressive
reduction in the level of problem assets over the last three years. The
following tables summarize the Bank's nonperforming assets (NPAs) as of
December 31, 1994 through 1998. Nonperforming assets, as a percentage of
total loans, continued to decline, reflecting continued improvements in
asset quality.
(In thousands) 1998 1997 1996 1995 1994
- ------------------------------------------------------------------------------------------
Nonaccrual Loans $2,103 $2,686 $4,091 $25,617 $32,200
Loans Past Due 90 Days or
More and Still Accruing 170 403 216 237 668
Restructured Loans 320 215 2,403 1,430 5,083
- ------------------------------------------------------------------------------------------
Total Nonperforming Loans: 2,593 3,304 6,710 27,284 37,951
- ------------------------------------------------------------------------------------------
Other Real Estate Owned 470 591 1,925 7,772 13,231
- ------------------------------------------------------------------------------------------
Total Nonperforming Assets: $3,063 $3,895 $8,635 $35,056 $51,182
==========================================================================================
NPL to Total Loans 0.64% 0.85% 1.70% 3.61% 3.90%
NPA to Total Loans plus OREO 0.75% 1.00% 2.20% 3.28% 1.97%
- ------------------------------------------------------------------------------------------
Excluded from the 1998 balances above are approximately $3.0 million of
internally classified loans. Management believes that these loans have well-
defined weaknesses which, if left unattended, could lead to collection
problems. Management maintains an internal listing, which includes these
loans, which is reviewed and updated monthly. The oversight process on these
loans includes an active risk management approach. A management committee
reviews the status of these loans each quarter and determines or confirms
the appropriate risk rating and accrual status. The findings of this review
process are instrumental in determining the adequacy of the loan loss
reserve.
Discussion of 1998 Events affecting Nonperforming Assets
Historically, the Bank has worked closely with borrowers to collect
obligations and pursued more vigorous collection efforts where necessary.
The Bank's Credit Department and Loan Workout functions provide resources to
address collection strategies for nonperforming assets.
(In thousands) 12-31-98 9-30-98 6-30-98 3-31-98 12-31-97
- ---------------------------------------------------------------------------------------
Nonaccrual Loans $2,103 $4,752 $4,853 $3,700 $2,686
Loans Past Due 90 Days or
More and Still Accruing 170 279 438 309 403
Restructured Loans 320 327 333 214 215
Other Real Estate Owned 470 818 377 599 591
- ---------------------------------------------------------------------------------------
Total $3,063 $6,176 $6,001 $4,822 $3,895
=======================================================================================
Significant events affecting NPAs are discussed below.
Nonaccrual Loans
Nonaccrual loans declined from $2.7 million at December 31, 1997 to $2.1
million at December 31, 1998. The continued decline results from the Bank's
efforts to proactively identify and resolve loans which present significant
risk of loss to the Bank. As a result, during 1998, management identified
approximately $6.5 million in accounts it perceived as having certain risks,
which were transferred to nonaccrual status. These transfers were offset by
continued resolution of nonaccrual accounts. Approximately $230 thousand in
loans were returned to accrual status; principal payments of approximately
$2.1 million were collected; nonaccruing loans totaling approximately $1.0
million were sold during the second and fourth quarters; and charge-offs
totaling $3.8 million further decreased the balance of nonaccruing loans.
Loans Past Due 90 Days or More and Still Accruing Interest
The Bank generally places loans that become 90 or more days past due in
nonaccrual status. If, in the opinion of management, the ultimate
collectibility of principal and interest is assured, loans may continue to
accrue interest and be left in this category. Included in this category are
loans which have reached maturity and have not been renewed on a timely
basis, for reasons other than financial capacity to pay. Balances of loans
90 or more days past due decreased $233 thousand from year end 1997 to year
end 1998. Approximately 63% of these balances carry a guaranty from the U.S.
Small Business Administration.
Restructured Loans
Restructured loans (TDRs) increased from $215 thousand at December 31, 1997
to $320 thousand at December 31, 1998.
Other Real Estate Owned
The Bank continued its success in 1998 in disposing of Other Real Estate
Owned ("OREO") and continues to aggressively market remaining OREO. The
balance of OREO decreased from $591 thousand at December 31, 1997 to $470
thousand at December 31, 1998. During the year, $973 thousand in loan
balances were transferred to OREO, offset by sale proceeds during 1998 of
$1.2 million, which included $101 thousand in gains. Of the sale proceeds,
$1.0 million was derived from the sale of two properties housing operating
branches of the Bank, portions of which are now leased back for branch
operations purposes.
Policies and Procedures Related to the Accrual of Interest Income
The Bank normally recognizes income on earning assets on the accrual basis,
which calls for the recognition of income as earned, rather than when it is
collected. The Bank's policy is to classify a loan 90 days or more past due
with respect to principal or interest as a nonaccruing loan, unless the
ultimate collectibility of principal and interest is assured. Income
accruals are suspended on all nonaccruing loans, and all previously accrued
and uncollected interest is typically charged against current income. A loan
remains in nonaccruing status until the factors which suggest doubtful
collectibility no longer exist, the loan is liquidated, or when the loan is
determined to be uncollectible and is charged off against the reserve for
possible loan losses. In those cases where a nonaccruing loan is secured by
real estate, the Bank can, and usually will, 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 the Bank
possession of the collateral in order to manage a future resale of the real
estate. Foreclosed property is recorded at the lower of its cost or
estimated fair value, less any estimated costs to sell. Any cost in excess
of the estimated fair value on the transfer date is charged to the reserve
for possible loan losses, while further declines in market values are
recorded as an expense in other noninterest expense in the statement of
operations.
Loan Portfolio Monitoring
The Bank's Board of Directors grants each loan officer the authority to
originate loans on behalf of the Bank. The Board also establishes
restrictions regarding the types of loans that may be granted and the
distribution of loan types within the Bank's portfolio, and sets loan
authority limits for each lender. These authorized lending limits are
established at least annually and are based upon the lender's knowledge and
experience. Loan requests that exceed a lender's authority are referred to
the Bank's credit department. All extensions of credit of $2.5 million or
greater to any one borrower, or related party interest, are reviewed and
approved by the Loan Committee of the Bank's Board of Directors.
Using a variety of management reports, the Bank's loan portfolio is
regularly monitored by the Board of Directors and credit department. The
loan portfolio as a whole, as well as individual loans, are reviewed for
loan performance, creditworthiness, and strength of documentation. The Bank
has hired an external loan review firm to assist in monitoring both the
commercial and residential loan portfolios. Credit risk ratings are assigned
to commercial loans and are routinely reviewed.
All loan officers are required to service their own loan portfolios and
account relationships. As necessary, loan officers or the loan workout
function takes remedial actions to assure full and timely payment of loan
balances.
Reserve for Possible Loan Losses
The reserve for possible loan losses is based on management's estimate of
the amount required to reflect the risks in the loan portfolio, based on
circumstances and conditions known or anticipated at each reporting date.
Merchants Bank reviews the adequacy of the Reserve for Possible Loan Losses
("RPLL") at least quarterly. Factors considered in evaluating the adequacy
of the reserve include previous loss experience, current economic conditions
and their effect on the borrowers, the performance of individual loans in
relation to contract terms and estimated fair values of properties to be
foreclosed. The method used in determining the amount of the RPLL is not
based on maintaining a specific percentage of RPLL to total loans or total
nonperforming assets. Rather, the methodology is a comprehensive analytical
process of assessing the credit risk inherent in the loan portfolio. This
assessment incorporates a broad range of factors, which indicate both
general and specific credit risk, as well as a consistent methodology for
quantifying probable credit losses. Losses are charged against the RPLL when
management believes that the collectibility of principal is doubtful. To the
extent management determines the level of anticipated losses in the
portfolio have significantly increased or diminished, the RPLL is adjusted
through current earnings. As part of the Bank's analysis of specific credit
risk, detailed and extensive reviews are done on larger credits and
problematic credits identified on the watched asset list, nonperforming
asset listings and internal credit rating reports. Loans deemed impaired at
December 31, 1998 totaled $3.9 million. Impaired loans have been allocated
$400 thousand of the RPLL.
Overall, management believes that the RPLL 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 RPLL.
The following table reflects the Bank's loan loss experience and activity in
the RPLL for the past five years.
Loan Losses and Reserve for Possible Loan Losses Reconciliation
December 31, 1998
(In thousands) 1998 1997 1996 1995 1994
- ----------------------------------------------------------------------------------------------------
Average Loans Outstanding $391,814 $394,289 $406,514 $481,047 $514,843
RPLL Beginning of Year 15,831 15,700 16,234 19,929 20,060
Charge-Off:
Commercial, Lease Financing
and all Other Loans (685) (483) (907) (3,671) (3,356)
Real Estate-Construction (18) (78) (602) (1,485) (1,159)
Real Estate-Mortgage (3,042) (763) (3,206) (12,942) (7,673)
Installment & Credit Cards (190) (372) (405) (263) (462)
- ----------------------------------------------------------------------------------------------------
Total Loans Charged Off (3,935) (1,696) (5,120) (18,361) (12,650)
- ----------------------------------------------------------------------------------------------------
Recoveries:
Commercial, Lease Financing
and all Other Loans 554 615 391 1,232 1,187
Real Estate-Construction - - 63 32 400
Real Estate-Mortgage 451 2,996 856 1,224 769
Installment & Credit Cards 136 78 125 78 163
- ----------------------------------------------------------------------------------------------------
Total Recoveries 1,141 3,689 1,435 2,566 2,519
- ----------------------------------------------------------------------------------------------------
Net Loan Losses (2,794) 1,993 (3,685) (15,795) (10,131)
- ----------------------------------------------------------------------------------------------------
Provision for Possible Loan Losses:
Charged to Operations(1) (1,737) (1,862) 3,150 12,100 10,000
- ----------------------------------------------------------------------------------------------------
RPLL End of Year $ 11,300 $ 15,831 $ 15,700 $ 16,234 $ 19,929
====================================================================================================
RPLL to Total Loans 2.79% 4.06% 4.05% 3.61% 3.90%
Net Loan Losses to Average Loans 0.71% 0.51% 0.91% 3.28% 1.97%
- ----------------------------------------------------------------------------------------------------
<FN>
<F1> The loan loss provision is charged to operating expense. When actual
losses differ from these estimates, and if adjustments are considered
necessary, they are reported in operations in the periods in which
they become known.
</FN>
During the fourth quarter of 1998, the Bank recorded a $1.6 million credit
provision for possible loan losses resulting in an overall credit provision
of $1.7 million in 1998. This reduction of the RPLL was primarily the result
of an internal review of the Bank's loan loss reserve requirement, which
considered the changing mix and improved quality of the loan portfolio, the
impact of conservative underwriting standards implemented in previous
periods, general economic conditions, and the resolution of a significant
troubled credit. The Bank's analysis has been substantiated by a
comprehensive assessment of its loan portfolio and review of its loan loss
reserve requirement by its external loan review firm during the fourth
quarter of 1998. The credit provision reduced the unallocated portion of the
RPLL from $5.2 million to $3.6 million. As of December 31, 1998 the
Company's reserve balances and ratios were still conservatively stated with
the reserve at 368% of nonperforming assets and 2.79% of total loans. The
negative loan loss provision in 1997 resulted from $2.16 million of
principal recovery received by the Bank during the fourth quarter of 1997 on
two previously charged down credits.
The continued high level of the RPLL reflects management's current
strategies and efforts to maintain the reserve at a level adequate to
provide for loan losses based on an evaluation of known and inherent risks
in the loan portfolio. Among the factors that management considers in
establishing the level of the reserve are overall findings from an analysis
of individual loans, the overall risk characteristics and size of the loan
portfolio, past credit loss history, management's assessment of current
economic and real estate market conditions and estimates of the current
value of the underlying collateral.
The Company takes all appropriate measures to restore nonperforming assets
to performing status or otherwise liquidate these assets in an orderly
fashion so as to maximize their value to the Company. There can be no
assurances that the Bank will be able to complete the disposition of
nonperforming assets without incurring further losses, or that the Bank will
continue to recognize substantial recoveries or credit provision for
possible loan losses such as those received during 1998 and 1997.
RISK MANAGEMENT
Management and the Board of Directors are committed to sound risk management
practices throughout the organization. The Company has developed and
implemented a centralized risk management monitoring program. Risks
associated with the Company's business activities and products are
identified and measured as to probability of occurrence and impact on the
Company (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 the
Company's risk profile from a macro perspective, while also serving as a
tool for assessing internal controls over financial reporting as required
under the FDIC Improvement Act.
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 its Board of Directors that are reviewed and approved annually. The Board
of Directors delegates responsibility for carrying out the asset/liability
management policies to the Asset and Liability Management Committee
("ALCO"). In this capacity the ALCO develops guidelines and strategies
impacting the Company's asset/liability management related activities based
upon estimated market risk sensitivity, policy limits and overall market
interest rate levels/trends.
Interest Rate Risk
Interest rate risk is the exposure to a movement in interest rates, which
could affect the Company's net interest income. It is the responsibility of
the Company's ALCO to manage interest rate risk which arises naturally from
imbalances in repricing, maturity and/or cash flow characteristics of the
Company's assets and liabilities. The ALCO is responsible for developing
asset/liability management strategies and tactics, and for ensuring that the
Board of Directors receives timely, accurate information regarding the
Bank's interest rate risk position at least quarterly. Techniques used by
the ALCO take into consideration the cash flow and repricing attributes of
balance sheet and off-balance sheet items and their relation to possible
changes in interest rates. The ALCO uses interest rate caps and floors to
help minimize the Bank's exposure to changes in interest rates. Through the
use of computerized modeling systems, and with the assistance of outside
consultants, the effect on the Company's net interest income of a possible
200 basis point change in interest rates, in rising and declining scenarios,
is determined and evaluated by management. The Bank has established a target
range for the change in net interest income, given a 200 basis point change
in interest rates, of zero to 5%. As of December 31, 1998, through the use
of such computer models, the change in net interest income for the 12 months
ending December 31, 1999 from the Company's expected or "most likely"
forecast is as follows:
Net Interest
Rate Change Income Sensitivity
--------------------------------------------------
Up 200 basis points (1.34)%
Down 200 basis points 2.94%
--------------------------------------------------
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:
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, reinvestment/replacement of asset and
liability cash flows, and others. 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.
Also, as market conditions vary from those assumed in the sensitivity
analysis, actual results will also differ due to: prepayment/refinancing
levels likely deviating from those assumed, the varying impact of interest
change caps or floors on adjustable rate assets, the potential effect of
changes in debt service levels of customers with adjustable rate loans,
depositor early withdrawals and product preference changes, and other
internal/external variables. Furthermore, the sensitivity analysis does not
reflect all actions that ALCO might take in responding to or anticipating
changes in interest rates.
The model used to perform the simulation assumes a parallel shift of the
yield curve over twelve months and reprices every interest-bearing asset and
liability on the Bank's balance sheet. The model uses contractual repricing
dates for variable products, contractual maturities for fixed rate products,
and product-specific assumptions for deposits such as NOW accounts and Money
Market accounts which are subject to repricing based on current market
conditions. Investment securities with call provisions are examined on an
individual basis in each rate environment to estimate the likelihood of a
call. The model also assumes that the rate at which certain mortgage related
assets prepay will vary as rates rise and fall, prepayment estimates are
derived from the Office of Thrift Supervision Net Portfolio Value Model.
The Company has entered into interest rate cap and floor contracts to
mitigate the effects on net interest income in the event interest rates on
variable rate deposits rise or rates on variable rate loans decline. The
notional principal amounts of contracts outstanding were $80 million, the
amortized cost of such contracts was $302 thousand and the fair value of the
contracts was $280 thousand as of December 31, 1998. The Company will
receive payments under these contracts in the event of specified changes in
certain interest rates. As of December 31, 1998 interest rate floors with a
notional amount of $30 million were in the money. Payments were received in
1999.
The Company's interest rate sensitivity gap ("gap") is pictured below. Gap
is defined as the difference between assets and liabilities repricing or
maturing within specified periods. An asset-sensitive position (positive
gap) indicates that there are more rate-sensitive assets than rate-sensitive
liabilities repricing or maturing within a specified time period, which
would imply a favorable impact on net interest income during periods of
rising interest rates. Conversely, a liability-sensitive position (negative
gap) generally implies a favorable impact on net interest income during
periods of falling interest rates. The Company's gap presentation may not
reflect the degrees to which interest earning assets and interest bearing
deposits respond to changes in market interest rates.
Repricing Date
- --------------------------------------------------------------------------------------------------------
One Day Over Six One Year
To Six Months To To Five Over Five
(In thousands) Months One Year Years Years Total
- --------------------------------------------------------------------------------------------------------
Assets
Loans $ 106,571 $ 57,410 $186,070 $ 44,141 $394,192
Mortgage Backed Securities 18,595 15,757 50,641 40,142 125,135
US Treasury & Agency Securities 14,978 200 25,797 5,230 46,205
Other Securities 3,883 306 2,561 1,543 8,293
Other Assets 2,000 - - 59,048 61,048
- --------------------------------------------------------------------------------------------------------
Total Assets $ 146,027 $ 73,673 $265,069 $150,104 $634,873
========================================================================================================
Liabilities and Stockholders' Equity
Noninterest-bearing Deposits - - - $ 85,998 $ 85,998
Interest-bearing Deposits $ 238,150 $ 54,290 $165,351 6,673 464,464
Borrowed Funds 9,283 - - 6,409 15,692
Other Liabilities - - - 7,890 7,890
Stockholders' Equity - - - 60,829 60,829
- --------------------------------------------------------------------------------------------------------
Total Liabilities and Stockholders'
Equity $ 247,433 $ 54,290 $165,351 $167,799 $634,873
========================================================================================================
Cumulative Gap $(101,406) $(82,023) $ 17,695
Gap as a % of Total Earning Assets (17.30)% (13.99)% 3.02%
- --------------------------------------------------------------------------------------------------------
Based on historical experience and the Bank's internal repricing policies,
it is the Bank's practice to present repricing of statement savings, savings
deposits and NOW account balances in the "one to five year" category. The
Bank's experience has shown that the rates on these deposits tend to be less
rate-sensitive than other types of deposits.
Credit Risk
A network of loan officers manages credit risk, with review by the Bank's
Credit Department and oversight by the Board of Directors. The Board of
Directors grants each loan officer the authority to originate loans on
behalf of the Bank and establishes policies regarding loan portfolio
diversification and loan officer lending limits. The Bank's loan portfolio
is continuously monitored, through the use of a variety of management
reports and with the assistance of an external loan review firm, for
performance, creditworthiness and strength of documentation. Credit ratings
are assigned to commercial loans and are routinely reviewed. When necessary,
loan officers or the loan workout function take remedial actions to assure
full and timely payment of loan balances. The Bank's policy is to
discontinue the accrual of interest on loans when scheduled payments become
contractually past due 90 or more days and the ultimate collectibility of
principal or interest becomes doubtful. Credit card balances 90 or more days
past due are charged off and consumer installment loans are charged off when
they reach 120 days past due.
Liquidity and Capital Resource Management
Liquidity, as it pertains to banking, can be defined as the ability to
generate cash in the most economical way to satisfy loan and deposit
withdrawal demand, and to meet other business opportunities that require
cash. Sources of liquidity for banks include short-term liquid assets, cash
generated from loan repayments and amortization, borrowing, deposit
generation and earnings. The Merchants Bank has a number of sources of
liquid funds, including $20 million in available Federal Funds lines of
credit at year-end 1998; an overnight line of credit with the Federal Home
Loan Bank ("FHLB") of $15 million; an estimated additional borrowing
capacity with the FHLB of $48 million; and the ability to borrow $100
million through the use of repurchase agreements, collateralized by the
Bank's investments, with certain approved counterparties. Additionally, the
Bank's investment portfolio is actively managed by the ALCO and is a strong
source of cash flow for the Bank. The portfolio is fairly liquid, with a
weighted average life of 5 years, and is available to be used as a source of
funds, if needed.
YEAR 2000
Introduction: The Company, like most users of computers, computer software,
and equipment utilizing computer software, faces a critical challenge
regarding the Year 2000 date change. The Year 2000 issue, which is common to
most corporations, and especially important to banks, concerns the inability
of information systems, primarily computer software programs, to properly
recognize and process date sensitive information as the Year 2000
approaches. If not corrected, many computer applications could fail or
create inaccurate results. The bank regulatory agencies which regulate the
conduct of the Company, the Bank and the Trust Company, through the auspices
of the Federal Financial Institutions Examination Council (FFIEC) have
issued compliance guidelines requiring financial institutions to develop and
implement plans to address the Year 2000 issue. During the past fifteen
months, the Company has devoted substantial time and resources toward
ensuring that the Company's and its subsidiaries' operations will not be
adversely impacted by the pending date change. The Bank's primary regulator,
the Federal Deposit Insurance Corporation, has been monitoring, and
continues to monitor, the Bank's planning and implementation process on a
regular basis. The Company has also contracted with a national accounting
firm to perform an independent review of the Company's Year 2000
preparations. These reviews commenced during the fourth quarter of 1998 and
will continue into 1999. The Company's management remains committed to the
continued deployment of the necessary internal and external resources toward
addressing the Year 2000 issue.
State of Readiness: As required by the Company's and its subsidiaries'
regulatory agencies, the Company, through its Year 2000 Committee (the
Committee), has developed a Year 2000 compliance plan. The Company's plan
addresses the five basic phases of achieving Year 2000 compliance; (i)
project management, (ii) awareness, (iii) assessment, (iv) testing and (v)
renovation and implementation. Project management began in the middle of
1997 as the Committee was formed. Since its formation, the Committee has met
on a regular basis to discuss and plan the specific actions that the
Company, the Bank and the Trust Company need to take to verify that the
Company and its subsidiaries will be prepared for the date change. In
addition, the Company has developed a strategy to ensure that its software
vendors are also taking steps to address the Year 2000 date change. The
Committee is comprised of senior executive officers of the Company, the Bank
and the Trust Company. The Committee is chaired by the Bank's Senior
Operations Officer, and includes the Company's Chief Financial Officer, the
Bank's Chief Auditor/Risk Management Officer, the Bank's Information Systems
Manager, the Bank's Credit Manager, the Bank's Deposit Operations Manager, a
Trust Company Officer and the Bank's Facilities/Administration Manager. The
Committee provides progress reports to the Company's senior management and
reports at least quarterly to the Company's Board of Directors.
Through the Committee, the Company has also taken steps to promote awareness
of the Year 2000 issue throughout its entire organization. In addition, the
Company has sought to raise the awareness of its vendors, service providers
and larger borrowing customers as to the Year 2000 issue in light of the
critical role these entities play in the operations of the Company. The
Committee has contacted each of these entities and requested a Year 2000
plan and testing information. The Company has received responses from more
than 98% of its vendors and service providers. The majority (92%) of the
Company's significant borrowers have also responded. The Committee intends
to follow-up with these customers throughout the next year and into the Year
2000.
Assessment is the process of identifying all mission-critical applications
that could be adversely affected by the date change. The Company's
assessment phase is substantially complete. Throughout its history,
independent of Year 2000 issues, the Company has sought to purchase its
critical core hardware and software from vendors who it perceives as having
strong reputations as leading financial industry service providers. The
Company has received and installed Year 2000 compliant software upgrades
from all mission critical vendors. Substantial progress has been made with
respect to the fourth phase of the Company's Year 2000 plan, testing.
Testing of the Company's core computer and peripheral equipment
infrastructure has been successfully completed and substantial progress has
been made in the testing of the infrastructure of the Company's personal
computer desktop network. Testing of mission critical customer accounting
software applications has begun and is targeted for completion in advance of
the FFIEC suggested testing completion date. All other systems and
applications have been scheduled for testing prior to September 30, 1999. In
the Plan, each of these non-mission critical systems has an established
target date by which steps must be taken to replace any non-compliant
systems. The Company is confident that all tests will be completed in
advance of those target dates.
The final phase of the Plan, renovation and implementation, involves
obtaining and implementing renovated software applications provided by the
Company's vendors. As noted above, this phase of the Plan has already
commenced and will continue throughout 1999. To date, the Company has not
identified any system which presents a material risk of not being Year 2000
compliant in a timely fashion or for which a suitable alternative cannot be
implemented.
Costs to Address the Year 2000 Issue: The total financial costs associated
with the Year 2000 problem cannot be predicted at this time with absolute
certainty. As may be expected, the Committee currently estimates that there
will be costs associated with replacing certain non-compliant software
and/or hardware. The Company has hired a full-time project coordinator to
oversee the testing phase of the Year 2000 project. Although no other staff
additions are currently planned, the Committee estimates that approximately
30-35 people (about 10% of our staff) are spending some portion of their
time working on the Year 2000 project. Additionally, the Company has hired a
third party to evaluate the Bank's loan loss reserve adequacy in light of
Year 2000 concerns. At this time, the Company does not anticipate a need for
any additional loan loss provision related specifically to Year 2000 risks.
The Company plans to replace many of the Bank's ATMs as well as upgrade
certain software and equipment. Management had approved the replacement of
the ATMs prior to Year 2000 budget planning since most were 15 to 20 years
old. Out of the total estimated $1.22 million in capital costs $862 thousand
is budgeted to upgrade the ATM network. The Bank has spent $680 thousand for
ATM and other Year 2000 upgrades in 1998. These costs have been, and when
incurred in the future will be, capitalized and depreciated over the
estimated useful lives of the assets, as such assets represent replacement
of existing equipment, which are not mainly being remediated for Year 2000.
Direct (non-capital expenditures) Year 2000 expenses incurred year-to-date
total approximately $163 thousand and have been charged to expense as
incurred. Additional expenses related to the project are currently estimated
to be $230 thousand and will be charged to expense as incurred.
Risks of Year 2000 Issues: The Year 2000 issue presents potential risks to
the Company, its subsidiaries and their operations. As stated above, the
Company purchases substantially all of its technology applications from
third parties that face the same Year 2000 challenge as the Company. Thus,
the Company's operations could be adversely affected if the operations of
these third parties are adversely affected by the Year 2000 issue. Most
significantly, the Company faces risks that are specific to the business of
banking. Included among these risks is the risk that the Year 2000 date
change may result in the inability to process and underwrite loan
applications, to credit deposits and withdrawals from customer accounts, to
credit loan payments or track delinquencies, to properly reconcile and
record daily activity or to engage in similar normal banking activities.
Additionally, if the Bank's commercial loan customers are not Year 2000
compliant and suffer adverse effects with respect to their own operations,
their ability to meet their obligations to the Bank could be adversely
affected. Furthermore, as a commercial bank, the Bank could potentially
experience deposit run-off prior to the Year 2000 date change as a result of
customer concern about the potential availability of their funds or a change
in interest rates. Moreover, to the extent that the risks posed by the Year
2000 problem are pervasive in data processing and transmission and
communications services worldwide, the Company cannot predict with any
certainty that its operations will remain materially unaffected after
January 1, 2000 or on dates preceding this date at which time post-January
1, 2000 dates become significant within the Bank's systems. Finally, to the
extent that certain utility and communication services used by the Company
face Year 2000 problems, the Company's operations could be disrupted.
Contingency Plans: In light of these risks and uncertainties, the Company
has developed and will continue to monitor contingency plans to mitigate the
risks associated with the Year 2000 date change and to provide a business
continuity strategy. The Company has developed these plans through building
on its internal Disaster Recovery/Contingency plans, which were updated
during the second quarter of 1998. This planning effort included a Business
Impact Analysis relating to mission critical systems and is the foundation
documentation that was used to finalize the Year 2000 mission critical
service provider Contingency plans.
CAPITAL RESOURCES
Capital growth is essential to support deposit and asset growth and to
ensure the strength and safety of the Company. Net income increased the
Company's capital by $9.8 million in 1998, $8.8 million in 1997, and $6.2
million in 1996.
The Bank and the Company are subject to various regulatory capital
requirements administered by banking regulatory agencies. To be considered
adequately capitalized under the regulatory framework for prompt corrective
action, the Bank and the Company must maintain minimum Tier-1 Leverage,
Tier-1 Risk-Based and Total Risk-Based Capital. The Bank and the Company
were above all regulatory minimums and considered well capitalized by the
regulators at December 31, 1998. The ratios for the Company are set forth
below:
Minimum to be
Well-Capitalized
Under Regulatory
(In thousands) Amount Percentage Guidelines
-------------------------------------------------------------------------
Tier-1 Risk-Based Capital $58,677 14.45% 6.0%
Total Risk-Based Capital 63,747 15.69% 10.0%
Tier-1 Leverage Capital 58,677 9.49% 5.0%
-------------------------------------------------------------------------
During the third quarter of 1998 the Company's Board of Directors approved a
stock repurchase program. Under the program the Company is authorized to
repurchase, through September 4, 1999, up to $2.2 million of its own
securities, approximately 2% of outstanding shares at that time. As of
December 31, 1998 the Company had purchased 40,000 shares of stock on the
open market, at a total cost of $960 thousand.
In July 1998, the Emerging Issues Task Force ("EITF") issued guidance on
Issue No. 97-14, "Accounting for Deferred Compensation Arrangements Where
Amounts Earned Are Held in a Rabbi Trust and Invested" (the "Guidance").
This Guidance establishes standards for reporting and accounting for certain
deferred compensation agreements the Company and certain directors of the
Company. This Guidance requires that the deferred compensation obligation be
classified in the "Stockholders' Equity" section of the balance sheets.
These amounts were previously classified as other liabilities in the
"Liabilities" section of the Balance Sheets. The Company adopted this
guidance prospectively on September 30, 1998 and on that date reclassified
deferred compensation obligations totaling $2.13 million into the
Stockholders' Equity section of the balance sheet as required.
EFFECTS OF INFLATION
The financial nature of the Company's balance sheet and statement of
operations is more clearly affected by changes in interest rates than by
inflation, but inflation does affect the Company because as prices increase
the money supply tends to increase, the size of loans requested tends to
increase, total bank assets increase, and interest rates are affected by
inflationary expectations. In addition, operating expenses tend to increase
without a corresponding increase in productivity. There is no precise
method; however, to measure the effects of inflation on the Company's
financial statements. Accordingly, any examination or analysis of the
financial statements should take into consideration the possible effects of
inflation.
FORM 10-K
The following is a copy, except for the exhibits, of the Annual Report of
Merchants Bancshares, Inc. (the "Company") on Form 10-K for the year ended
December 31, 1998, filed with the Securities and Exchange Commission (the
"Commission").
Certain information included herein is incorporated by reference from the
Company's 1998 Annual Report to Shareholders ("Annual Report") as indicated
below. Except for those portions of the Annual Report which are expressly
incorporated herein by reference, the Annual Report is not to be deemed
filed with the Commission. The Annual Report and Form 10-K have not been
approved or disapproved by the Commission, nor has the Commission passed
upon the accuracy or adequacy of the same.
TABLE OF CONTENTS
Part I Page Reference
- ---------------------------------------------------------------------------------------------------------------
Item 1-Business 51-56
Item 2-Properties 56-57
Item 3-Legal Proceedings 57-58
Item 4-Submission of Matters to a Vote of Security Holders 58
Part II
- ---------------------------------------------------------------------------------------------------------------
Item 5-Market for Registrant's Common Equity and Related Stockholder Matters 59
Item 6-Selected Financial Data 59
Item 7-Management's Discussion and Analysis of Financial Condition and Results of Operations 33-49
Item 7a-Quantitative and Qualitative Disclosures about Market Risk 44-46
Item 8-Financial Statements and Supplementary Data 3-32
Item 9-Changes in and Disagreements with Accountants on Accounting and Financial Disclosures 61
Part III *
- ---------------------------------------------------------------------------------------------------------------
Item 10-Directors and Executive Officers of the Registrant 61
Item 11-Executive Compensation 61
Item 12-Security Ownership of Certain Beneficial Owners and Management 61
Item 13-Certain Relationships and Related Party Transactions 61
Part IV **
- ---------------------------------------------------------------------------------------------------------------
Item 14-Exhibits, Financial Statement Schedules, and Reports on Form 8-K 61-63
Signatures 64
<FN>
- --------------------
<F*> The information required by Part III is incorporated herein by
reference from the Company's Proxy Statement for the Annual Meeting
of Shareholders to be held on April 20, 1999.
<F**> A list of exhibits in the Form 10-K is set forth on the Exhibit Index
included in the Form 10-K filed with the Commission and incorporated
herein by reference. Copies of any exhibit to the Form 10-K may be
obtained from the Company by contacting Shareholder Communications,
Merchants Bancshares, Inc., P.O. Box 1009, Burlington, VT 05402. All
financial statement schedules are omitted since the required
information is included in the consolidated financial statements of
the Company and notes thereto in the Annual Report.
</FN>
PART I
ITEM 1-BUSINESS
Merchants Bancshares, Inc. (the "Company") is a bank holding company
originally organized under Vermont law in 1983 for the purposes of owning
all of the outstanding capital stock of Merchants Bank (the "Bank") and
providing greater flexibility in helping the Bank achieve its business
objectives. Merchants Bank, which is the Company's primary subsidiary, is a
Vermont commercial bank with 33 full-service offices.
Merchants Bank was organized in 1849 and assumed a national bank charter in
1865, becoming The Merchants National Bank of Burlington, Vermont. On
September 6, 1974, the Bank converted its national charter to a Vermont
state commercial bank charter, adopting its current name, Merchants Bank.
Since 1971, the Bank has acquired by merger seven Vermont banking
institutions, and acquired the deposits of two other Vermont banks. As of
December 31, 1998 the Bank operated one of the largest commercial banking
operations in Vermont, with deposits totaling $550 million, loans of $405
million, and total assets of $635 million, on a consolidated basis.
The Bank designs its products to provide customers a clear alternative to
the local, regional and national financial service providers. The Bank's
simplified LYNX product line was developed using the image of the lynx
feline to connote speed and agility. Lynx also implies that a customer's
accounts can be linked together to provide a comprehensive approach to
their financial needs. The Bank's products have all been designed to be
easy for the customer to understand and for the Bank's staff to deliver.
Merchants Trust Company (the "Trust Company"), a wholly owned subsidiary of
the Bank, is a Vermont corporation chartered in 1870 for the purpose of
offering fiduciary services including estate settlement, testamentary
trust, guardianship, agency, intervivos trust and employee benefit plan
services. The Trust Company also operates a discount brokerage office
through Olde Discount Corporation, enabling investors to purchase or sell
stocks and bonds on a discounted commission schedule. As of December 31,
1998, the Trust Company had fiduciary responsibilities for assets having a
market value in excess of $334 million, of which more than $207 million
constituted managed assets. Total revenue of the Trust Company for 1998 was
$1,910 thousand; total expenses were $1,118 thousand resulting in pretax
net income of $877 thousand for the year. This net income is included in
the consolidated tax return of its parent company, the Merchants Bank.
Merchants Properties, Inc., a wholly owned subsidiary of the Company, was
organized for the purpose of developing and owning affordable rental
housing units throughout the state of Vermont. As of December 31, 1998,
Merchants Properties, Inc. owned one development located in Enosburg,
Vermont, consisting of a 24-unit low-income family rental housing project.
Total assets of this Merchants Properties, Inc. at December 31, 1998 were
$1.2 million.
RETAIL SERVICES
The Bank offers a variety of consumer financial products and services
designed to satisfy the deposit and loan needs of its retail customers. The
Bank's retail products include interest-bearing and noninterest-bearing
checking accounts, money market accounts, club accounts, and short-term and
long-term certificates of deposit. The Bank also offers customary check
collection services, wire transfers, safe deposit box rentals, and
automated teller machine (ATM) cards and services.
In 1997, the Bank extended its commitment to automation by introducing a
debit card and by expanding its automated overdraft protection. Using the
BankLYNX[SM] Check Card, in addition to standard ATM transactions,
customers can pay for purchases at locations that accept VISA and can also
use the card for standard ATM transactions. With expanded automated
overdraft protection, customers can use a savings account and/or a home
equity line of credit as overdraft protection for a checking account. The
customer may choose either or both accounts to cover overdrafts.
During 1998 the Bank converted all of its passbook savings account to
statement savings accounts and introduced its MoneyLYNX[TM] Money Market
Account as its primary savings vehicle. MoneyLYNX[TM] pays interest at
tiered levels beginning with the first dollar in the account, and charges
fees only under limited circumstances. Passbook savings accounts and
statement savings accounts are no longer offered as new accounts.
FreedomLYNX[R] checking is available with no service charges to customers
who have, at least monthly, an automatic deposit to the account or an
automatic debit from the account to pay a Merchants Bank loan and to
customers who qualify for a BankLYNX[SM] Check Card or who use
PhoneLYNX[SM] or PCLYNX[R] Bill Payment Services. The account pays interest
on higher balances with a tiered rate structure. No minimum balance is
required. During 1999, to celebrate its 150th anniversary, the Bank will
drop all electronic qualifications for the FreedomLYNX[R] account and offer
the account free for life. This offer will begin on February 15 and ends on
May 28. All existing FreedomLYNX[R] accounts will be converted to Free for
Life on February 15. The Bank continues to offer Bottom Line Checking, an
account that provides for a flat service charge up to a maximum number of
checks.
The Bank continues to offer ATM cards, debit cards, ATF (automatic transfer
of funds) to cover overdrafts, EFT (electronic funds transfer) to automate
transfers between accounts, PCLYNX[R] bill payment services and the
PhoneLYNX[SM] telephone banking system. In 1999, the Bank plans to expand
its automated services by introducing a retail home banking system through
the Internet.
The Bank continues to provide strong customer service. Each of the Bank's
33 full-service branch offices is led by a branch president or manager who
has consumer lending authority for the full range of retail credit
services. Additionally, the Bank has 35 ATM locations throughout Vermont,
and maintains a customer call center with expanded hours of operation.
COMMERCIAL SERVICES
Branch presidents are being given small business lending authority up to a
prescribed limit. The eleven corporate banking officers and eight corporate
banking administrators provide commercial credit services throughout the
state of Vermont to customers requiring business credit above the
prescribed authorities of the branch presidents.
In late 1998 the Bank developed a revitalized approach to small business
markets in the state of Vermont. The retail branch network services
approximately 75% of the commercial customers of the Bank. The Bank's
Corporate Sales staff services the balance, primarily larger enterprises.
Small business customers are being introduced to the Bank's new
CommerceLYNX[TM] program. CommerceLYNX[TM] is a package of business banking
services, including low cost electronic checking, investment accounts,
streamlined credit application, and small business "Health Check". The
Bank's philosophy of simplifying product offerings and minimizing fees has
been applied to this program. Branch presidents are trained to offer this
service, leading with the introduction of small business financing options
and the value of utilizing the efficient transaction accounts.
CommerceLYNX[TM] will be tested in 1999 in 10 pilot markets throughout the
state. A dedicated Sales Manager will advance the program for more
pervasive introduction throughout the state in the year 2000.
The Bank offers a variety of commercial checking accounts. Commercial
Checking uses an earnings credit rate to help offset service charges. Small
Business Checking is designed for the smaller business carrying lower
balances and reduced account activity. Investment opportunities are
available to businesses in the form of savings accounts and money market
accounts. The Bank's cash management services provide additional investment
opportunities through the Cash Sweep Program. Other cash management
services include funds concentration. The Bank offers on-line banking
services through PCLYNX[R] Corporate and PCLYNX[R] Small Business. These
products allow businesses to view their account histories, order stop
payments, transfer between accounts, transmit ACH batches and order both
domestic and foreign wire transfers.
Other miscellaneous commercial banking services include night depository,
coin and currency handling, lockbox and balance reporting services.
Employee benefits management and related fiduciary services are available
through the Trust Company.
TYPES OF CREDIT OFFERINGS
Consumer Loans:
- ---------------
Financing is provided for new or used automobiles, boats, airplanes,
recreational vehicles and new mobile homes. Home improvement and home
equity lines of credit, Master Card credit cards and various collateral
loans and personal loans are also available.
Real Estate Loans:
- ------------------
Financing is available for one-to-four-family residential mortgages;
multifamily mortgages; residential construction; mortgages for seasonal
dwellings; and commercial real estate mortgages. The Bank offers both fixed
rate and adjustable rate mortgages for residential properties. The Bank
closed over 750 mortgages in 1998 with an average loan of approximately $76
thousand and a term of approximately 15 years. The process and the product
have been streamlined to make the product easier to use and simpler for our
33 branch presidents to deliver.
Commercial Loans:
- -----------------
Financing for business inventory, accounts receivable, fixed assets, lines
of credit for working capital, community development, irrevocable letters
of credit, business credit cards and U.S. Small Business Administration
loans are available.
COMPETITION
The Bank competes for deposit and loan business with numerous other
commercial and savings banks, savings and loan associations, credit unions,
and other non-bank financial providers. As of December 31, 1998, there were
more than 25 state and national banking institutions operating in Vermont.
In addition, the number of other non-bank financial service providers
competing in Vermont has increased dramatically. As a bank holding company
and state-chartered bank, respectively, the Company and the Bank are
subject to extensive regulation and supervision, including, in many cases,
regulation that limits the type and scope of their activities. These non-
financial institutions which compete with the Company and the Bank are not
subject to such extensive regulation and supervision. Competition from
nationwide banks, as well as local institutions continues to be aggressive
At year-end 1998, the Bank was one of the largest state chartered banks in
Vermont, enjoying a strong competitive franchise within the state, with 33
banking offices as identified in Item 2 (A).
Consolidation within the overall banking industry nationally continues to
change the competitive environment in which we operate. Locally, the
proposed merger between the Chittenden Bank and Vermont National Bank will
consolidate two of the state's largest banks.. However, there may be
opportunities for business development by the Bank in shared market
communities as a result of the continued consolidation in the banking
industry.
No material part of the Bank's business is dependent upon one, or a few,
customers, or upon a particular market segment, the loss of which would
have a materially adverse impact on the operations of the Bank.
NUMBER OF EMPLOYEES
As of December 31, 1998, the Company had three officers: Joseph L. Boutin,
President and Chief Executive Officer; Janet Spitler, Treasurer; and
Jennifer L. Varin, Secretary. No officer of the Company is on a salary
basis.
As of December 31, 1998, the Bank employed 220 full-time and 47 part-time
employees, representing a full-time equivalent complement of 246 employees;
the Merchants Trust Company employed 14 full-time employees. The Bank and
the Trust Company maintain comprehensive employee benefits programs which
provide major medical insurance, hospitalization, dental insurance, long-
term and short-term disability insurance, life insurance and a 401(k)
Employee Stock Ownership Plan.
REGULATION AND SUPERVISION
General
As a bank holding company registered under the Bank Holding Company Act of
1956, as amended (the "BHCA"), the Company is subject to substantial
regulation and supervision by the Federal Reserve Board. As a state-
chartered bank, the Bank is subject to substantial regulation and
supervision by the Federal Deposit Insurance Corporation (the "FDIC") and
by applicable state regulatory agencies. To the extent that the following
information describes statutory or regulatory provisions, it is qualified
in its entirety by reference to those particular statutory provisions. Any
change in applicable law or regulation may have a material effect on the
business and prospects of the Company and the Bank.
The Company is required by the BHCA to file with the Federal Reserve Board
an annual report and such additional reports as the Federal Reserve Board
may require. The Federal Reserve Board also makes periodic inspections of
the Company and its subsidiaries. The BHCA requires every bank holding
company to obtain the prior approval of the Federal Reserve Board before it
may acquire substantially all of the assets of any bank, or ownership or
control of any voting shares of a bank, if, after such acquisition, it
would own or control, directly or indirectly, more than 5% of the voting
shares of such bank. Additionally, as a bank holding company, the Company
is prohibited from acquiring ownership or control of 5% or more of any
company not a bank or from engaging in activities other than banking or
controlling banks except where the Federal Reserve Board has determined
that such activities are so closely related to banking as to be a "proper
incident thereto."
Dividends
General. The Company is a legal entity separate and distinct from the Bank
and its other non-bank subsidiaries. The revenue of the Company (on a
parent company only basis) is derived primarily from interest and dividends
paid to the corporation by its subsidiaries. The right of the Company, and
consequently the right of stockholders of the Company, to participate in
any distribution of the assets or earnings of any subsidiary through the
payment of such dividends or otherwise is necessarily subject to the prior
claims of creditors of the subsidiary (including depositors, in the case of
banking subsidiaries), except to the extent that certain claims of the
Company in a creditor capacity may be recognized.
The payment of dividends by the Company is determined by its board of
directors based on the consolidated Company's liquidity, asset quality
profile, capital adequacy, and recent earnings history, as well as economic
conditions and other factors, including applicable government regulations
and policies and the amount of dividends payable to the Company by its
subsidiaries.
It is the policy of the Federal Reserve Board that banks and bank holding
companies, respectively, should pay dividends only out of current earnings
and only if after paying such dividends the bank or bank holding company
would remain adequately capitalized. Federal banking regulators also have
authority to prohibit banks and bank holding companies from paying
dividends if they deem such payment to be unsafe or unsound practice. In
addition, it is the position of the Federal Reserve Board that a bank
holding company is expected to act as a source of financial strength to its
subsidiary banks.
State law requires the approval of state bank regulatory authorities if the
dividends declared by state banks exceed prescribed limits. The payment of
any dividends by the Company's subsidiaries will be determined based on a
number of factors, including the subsidiary's liquidity, asset quality
profile, capital adequacy and recent earnings history.
Legislation and Related Matters
General. In addition to extensive existing government regulation, federal
and state statutes and regulations are subject to changes that may have
significant impact on the way in which banks may conduct business. The
likelihood and potential effects of any such changes cannot be predicted.
Legislation enacted in recent years has substantially increased the level
of competition among commercial banks, thrift institutions and non-banking
institutions, including insurance companies, brokerage firms, mutual funds,
investment banks, finance companies and major retailers. In addition, the
existence of banking legislation such as the Federal Deposit Insurance
Corporation Improvement Act of 1991 ("FDICIA") have affected the banking
industry by, among other things, broadening the regulatory powers of the
federal banking agencies in a number of areas. The following summary is
qualified in its entirety by the text of the relevant statutes and
regulations.
FDICIA. The FDICIA, which was enacted on December 19, 1991, provides for,
among other things, increased funding for the Bank Insurance Fund ("BIF")
of the FDIC and expanded regulation of depository institutions and their
affiliates, including parent holding companies. A summary of certain
material provisions of FDICIA and its regulations is provided below.
Prompt Corrective Action. The FDICIA provides the federal banking agencies
with broad powers to take prompt corrective action to resolve problems of
insured depository institutions, depending upon a particular institution's
level of capital. The FDICIA establishes five tiers of capital measurement
for regulatory purposes ranging from "well-capitalized" to "critically
undercapitalized." A depository institution may be deemed to be in a
capitalization category that is lower than is indicated by its actual
capital position under certain circumstances. As of December 31, 1997, the
Bank was classified as "well-capitalized" under the applicable prompt
corrective action regulations.
Brokered Deposits. Under the FDICIA, a depository institution that is well-
capitalized may accept brokered deposits. A depository institution that is
adequately capitalized may accept brokered deposits only if it obtains a
waiver from the FDIC, and may not offer interest rates on deposits
"significantly higher" than the prevailing rate in its market. An
undercapitalized depository institution may not accept brokered deposits.
Safety and Soundness Standards. The FDICIA, as amended, directs each
federal banking agency to prescribe safety and soundness standards for
depository institutions relating to internal controls, information systems,
internal audit systems, loan documentation, credit underwriting, interest
rate exposure, asset growth, compensation, asset-quality, earnings and
stock valuation. The Community Development and Regulatory Improvement Act
of 1994 amended FDICIA by allowing federal banking activities to publish
guidelines rather than regulations concerning safety and soundness.
The Federal Reserve Board has finalized these safety and soundness
guidelines. These guidelines relate to the management policies of financial
institutions and are designed, in large part, to implement the safety and
soundness criteria outlined in FDICIA. These guidelines will be published
after the other federal bank regulatory agencies have developed their
guidelines. At this time, it is not known what effect the applicable
guidelines will have on the current practices of the Company or the Bank.
FDICIA also contains a variety of other provisions that may affect the
Company's and the Bank's operations, including reporting requirements,
regulatory guidelines for real estate lending, "truth in savings"
provisions, and the requirement that a depository institution give 90 days'
prior notice to customers and regulatory authorities before closing any
branch. Certain of the provisions in FDICIA have recently been or will be
implemented through the adoption of regulations by the various federal
banking agencies and, therefore, their precise impact cannot be assessed at
this time.
Capital Guidelines. Under the uniform capital guidelines adopted by the
federal banking agencies, a well-capitalized institution must have a
minimum ratio of total capital to risk-adjusted assets (including certain
off-balance sheet items, such as standby letters of credit) of 10%, a
minimum Tier 1 (comprised of common equity, retained earnings, minority
interests in the equity accounts of consolidated subsidiaries and a limited
amount of noncumulative perpetual preferred stock, less deductible
intangibles) capital-to-total risk based assets of 6% and a minimum
leverage ratio (Tier 1 capital to average quarterly assets, net of
goodwill), of 5%.
Under federal banking laws, failure to meet the minimum regulatory capital
requirements could subject a banking institution to a variety of
enforcement remedies available to federal regulatory authorities, including
the termination of deposit insurance by the FDIC and seizure of the
institution.
Community Investment Act. Pursuant to the Community Reinvestment Act
("CRA") and similar provisions of Vermont law, regulatory authorities
review the performance of the Company and the Bank in meeting the credit
needs of the communities served by the Bank. The applicable regulatory
authorities consider compliance with this law in connection with the
applications for, among other things, approval of branches, branch
relocations and acquisitions of banks and bank holding companies. The Bank
received a "satisfactory" rating at its most recent CRA examination.
Interstate Banking As of September 29, 1995, the Riegle-Neal Interstate
Banking and Branching Efficiency Act of 1994 (the "RNA") permitted
adequately capitalized and managed bank holding companies to acquire
control of banks in any state. Additionally, beginning on June 1, 1997, the
RNA provides for banks to branch across state lines, although individual
states are authorized to permit interstate branches earlier or to elect to
opt out entirely.
Other Proposals
Other legislative and regulatory proposals regarding changes in banking,
and the regulation of banks and other financial institutions, are regularly
considered by the executive branch of the federal government, Congress and
various state governments, including Vermont, and state and federal
regulatory authorities. It cannot be predicted what additional legislative
and/or regulatory proposals, if any, will be considered in the future,
whether any such proposals will be adopted or, if adopted, how any such
proposals would affect the Company or the Bank.
ITEM 2-PROPERTIES
A. SCHEDULE OF BANKING OFFICES BY LOCATION
Merchants Bank operates thirty-three banking facilities as indicated in
Schedule A below. Administrative offices and the operations data processing
center are located at 275 Kennedy Drive, South Burlington, Vermont.
Barre 105 North Main Street(2) Branch office
Bennington 406 Main Street, Putnam Square(2) Branch office
North Bennington 5 Bank Street Branch office
Bradford 1 Main Street(2) Branch office
Brattleboro 205 Main Street(2) Branch office
Bristol 15 West Street Branch office
Burlington 164 College Street Merchants Trust Company
Corporate Offices
172 College Street Branch office
1014 North Avenue Branch office
Colchester 22 Bissette Drive(2) Branch office
Enosburg 371 Main Street Branch office
Essex Junction 54 Pearl Street Branch office
Fair Haven 97 Main Street Branch office
Fairlee 501 U.S. Route 5 North(2) Branch office
Groton 258 Scott Highway Branch office
Hardwick 84 VT Route 15 West Branch office
Hinesburg 26 Ballards Corner Branch office
Jericho 205 VT Route 15 Branch office
Johnson 103 Lower Main Street Branch office
Manchester Center 4996 Main Street Branch office
Newbury 4976 Main Street South Branch office
Northfield 70 Depot Square(2) Branch office
St. Johnsbury 481 Portland Street Branch office
South Burlington 50 White Street Branch office
929 Shelburne Road(1) Branch office
275 Kennedy Drive Service Center
South Hero 301 Route 2 Branch office
Springfield 2 Chester Road, Suite 15(2) Branch office
East Thetford 332 Route 113(2) Branch office
Vergennes 25 Monkton Road Branch office
Wallingford 137B North Main Street(2) Branch office
Wilmington 24 West Main Street Branch office
Windsor 160 Main Street Branch office
Winooski 364 Main Street Branch office
<FN>
- --------------------
<F1> Facilities owned by the Bank are located on leased land.
<F2> Facilities located on leased land with improvements also leased.
</FN>
ITEM 3-LEGAL PROCEEDINGS
The Bank is a counterclaim defendant in a litigation entitled "Pasquale and
Vatsala Vescio, Counterclaim Plaintiffs v. The Merchants Bank, Counterclaim
Defendant", now pending in the United States Bankruptcy Court for the
District of Vermont.
In this litigation, the Vescios have made a number of "lender liability"
claims dealing with a commercial development known as Brattleboro West in
Brattleboro, Vermont. The pending litigation arose out of a suit to
foreclose on several real estate mortgages and personal property originally
delivered to the Bank as collateral by the Vescios in connection with the
financing of a supermarket in the Brattleboro West project and various
other projects.
Among other things, the Vescios have alleged that the Bank or its
representatives violated supposed oral promises in connection with the
origination and funding of the financing, and have claimed that the Bank is
liable to them for damages based on the Bank's supposed "control" of the
project and its alleged breach of covenants of "good faith" which the
plaintiffs believe are to be implied from the loan documents. In addition,
the plaintiffs have contended that the Bank breached a duty of care they
believe it owed to them, and have claimed that the Bank should not have
exercised its contract rights when the loan went into default, but should
have worked out the default in a way that was more favorable to the
borrowers. Trial concluded in United States Bankruptcy Court in November
1998. Although it is not possible at this stage to predict the outcome of
this litigation, the Bank believes that it has meritorious defenses to the
plaintiffs' allegations. The Bank intends to vigorously defend itself
against these claims.
The Company, the Bank, the Trust Company (the "Companies") and certain of
their directors are defendants in a lawsuit filed in November of 1994 (the
"Vermont Proceedings"). The Vermont Proceedings arose from certain
investments managed for Trust company customers and placed in the Piper
Jaffray Institutional Government Income Portfolio (the "Portfolio"). In
December of 1994, the Companies made payments to the Trust Company
customers in amounts that the Companies believed reimbursed those customers
fully for Portfolio losses. The United States District Court for the
District of Vermont has dismissed the Plaintiff's claims in the Vermont
Proceedings with prejudice, as moot, and ordered payment of approximately
$99,000 in attorney's fees. The Plaintiff and his attorneys appealed those
District Court orders to the Second Circuit Court of Appeals, and the
Companies appealed on certain limited issues. By Order dated January 28,
1999 the Second Circuit Court affirmed those District Court orders in all
material respects and remanded the case to the District Court with
instructions to clarify whether the dismissal of the claims as moot was to
be with prejudice. Still pending before the Second Circuit is a separate
appeal from the District Court's denial of Plaintiff's requests for
sanctions and other relief based on asserted improprieties in the defense
of the litigation. The Companies believe the Plaintiff's assertions in that
regard are groundless and will continue to seek denial of Plaintiff's
requests.
The Companies have separately pursued claims against others on account of
the losses suffered as a result of the investments in the Portfolio. Claims
against Piper Jaffray Companies, Inc. were joined with the claims of others
in a class action in the United States District Court for the District of
Minnesota (the "Minnesota Proceedings"). The Minnesota Proceedings were
settled by the parties and in February of 1997 the District Court ordered
the net share of the settlement proceeds attributable to the Trust
Company's investments to be paid to the Trust Company, starting
approximately 60 days after the Court's order becomes final, except to the
extent, if at all, any other court with jurisdiction has sooner given leave
for some or all of those payments to be deposited with such other court
pursuant to applicable rules. The attorneys representing the Plaintiff in
the Vermont Proceedings and also representing, in the Minnesota
Proceedings, the beneficiaries of four other Trust Company accounts,
appealed that order to the Eighth Circuit Court of Appeals. By Per Curiam
decision filed July 25, 1998, the Eighth Circuit denied that appeal. The
attorneys for the Plaintiffs have filed a petition for certiorari to the
United States Supreme Court, which has not yet acted upon it. The same
attorneys also have announced an intention to initiate separate proceedings
to seek to intercept at least a portion of any payments coming from the
Minnesota Proceedings, in order to seek to deprive the Companies of at
least a portion of the reimbursement that otherwise could be available. Any
recovery by the Companies from the Minnesota Proceedings is subject to the
terms of an agreement between the Companies and their insurance carrier,
which reimbursed the Companies, in part, for the December, 1994 payments.
The Company and certain of its subsidiaries have been named as defendants
in various legal proceedings arising from their normal business activities.
Although the amount of any ultimate liability with respect to such
proceedings cannot be determined, in the opinion of management, based upon
the opinion of counsel on the outcome of such proceedings, any such
liability will not have a material effect on the consolidated financial
position of the Company and its subsidiaries.
ITEM 4-SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
During the fourth quarter of calendar year 1998 no matters were submitted
to a vote of security holders through a
solicitation of proxies or otherwise.
PART II
ITEM 5-MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
The common stock of the Company is traded on the over-the-counter market
and the price is quoted on the NASDAQ National Market Stock Exchange under
the trading symbol MBVT. Quarterly stock prices during the last eight
quarters are as indicated below based upon quotations as provided by the
National Association of Securities Dealers, Inc. Prices of transactions
between private parties may vary from the ranges quoted below.
Quarter Ended High Low
------------------------------------------
December 31, 1998 $26.500 $17.000
September 30, 1998 34.625 21.250
June 30, 1998 34.875 32.000
March 31, 1998 34.625 30.750
December 31, 1997 33.500 26.000
September 30, 1997 29.000 20.500
June 30, 1997 21.125 18.000
March 31, 1997 21.250 18.250
------------------------------------------
As of February 23, 1999 the Company had 1,260 registered shareholders. The
Company declared and distributed dividends totaling $0.71 per share during
1998. In January 1999 the Company declared a dividend of $0.19 per share.
Future dividends will depend upon the financial condition and earnings of
the Company and its subsidiaries, their need for funds and other factors,
including applicable government regulations.
ITEM 6-SELECTED FINANCIAL DATA
The supplementary financial data presented in the following table contains
information highlighting certain significant trends in the Company's
financial condition and results of operations over an extended period of
time.
The following information should be analyzed in conjunction with
Management's Discussion and Analysis of Financial Condition and Results of
Operations and with the year-end audited consolidated financial statements
as contained in the 1998 Annual Report to Shareholders, a copy of which is
attached as an addendum to this Form 10-K.
Merchants Bancshares, Inc.
Five Year Summary of Operations
(Not Covered by Report of Independent Public Accountants)
For the Years Ended December 31,
(In thousands except per share data) 1998 1997 1996 1995 1994
- -------------------------------------------------------------------------------------------------------------
INCOME STATEMENT
Interest and Investment Income $ 48,023 $ 48,158 $ 48,004 $ 51,315 $ 53,319
Interest Expense 18,530 18,238 18,672 23,002 22,377
- -------------------------------------------------------------------------------------------------------------
Net Interest Income 29,493 29,920 29,332 28,313 30,942
Provision for Possible Loan Losses (1,737) (1,862) 3,150 12,100 10,000
- -------------------------------------------------------------------------------------------------------------
Net Interest Income after Provision for Loan
Losses 31,230 31,782 26,182 16,213 20,942
- -------------------------------------------------------------------------------------------------------------
Other Income 7,312 7,916 9,363 12,766 15,038
Other Expense 25,472 28,482 27,489 36,606 41,712
- -------------------------------------------------------------------------------------------------------------
INCOME (LOSS) BEFORE INCOME TAXES 13,070 11,216 8,056 (7,627) (5,732)
Provision (benefit) for Income Taxes 3,248 2,383 1,832 (3,785) (2,842)
- -------------------------------------------------------------------------------------------------------------
NET INCOME (LOSS) $ 9,822 $ 8,833 $ 6,224 $ (3,842) $ (2,890)
=============================================================================================================
SELECTED AVERAGE BALANCES
- -------------------------------------------------------------------------------------------------------------
Total Assets $603,312 $578,090 $580,860 $642,487 $709,077
Average Earning Assets 566,126 540,830 533,192 575,551 620,070
Loans 391,814 394,289 406,514 481,047 514,843
Total Deposits 525,460 505,987 513,923 556,242 598,305
Long-Term Debt 6,890 6,418 8,925 28,707 45,433
Shareholders' Equity 56,243 49,140 43,111 40,848 46,331
Shareholders' Equity plus Loan Loss Reserve 71,033 65,407 59,094 58,794 65,322
- -------------------------------------------------------------------------------------------------------------
SELECTED RATIOS
- -------------------------------------------------------------------------------------------------------------
Net Income (Loss) to:
Average Shareholders' Equity 17.46% 17.98% 14.44% (9.41)% (6.24)%
Average Assets 1.63 1.53 1.07 (0.60) (0.41)
Average Shareholders' Equity to
Average Total Assets 9.32 8.50 7.42 (6.36) (6.53)
Common Dividend Payout Ratio 32 25 - - -
Loan Loss Reserve to Total Loans at Year End 2.79 4.06 4.05 3.61 3.90
Net Charge-Offs to Average Loans 0.71 (0.66) 1.26 3.28 1.97
- -------------------------------------------------------------------------------------------------------------
PER SHARE
- -------------------------------------------------------------------------------------------------------------
Basic Earnings per Common Share $2.22 $2.00 $1.45 $(0.90) $(0.68)
Diluted Earnings Per Common Share 2.21 1.99 1.45 (0.90) (0.68)
Cash Dividends Paid 0.71 0.50 - - -
Year End Book Value 13.84 11.95 10.78 9.38 10.00
- -------------------------------------------------------------------------------------------------------------
OTHER
- -------------------------------------------------------------------------------------------------------------
Cash Dividends Paid $ 3,051 $ 2,141 $ - $ - $ -
- -------------------------------------------------------------------------------------------------------------
ITEM 7-MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RE-
SULTS OF OPERATIONS
Please refer to pages 33-49 for Management's Discussion and Analysis of
Financial Condition and Results of Operations.
ITEM 8-FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The consolidated balance sheets of Merchants Bancshares, Inc. as of
December 31, 1998 and 1997, and the related consolidated statements of
operations, changes in stockholders' equity and cash flows for each of the
three years in the period ended December 31, 1998, together with the
related notes and the opinion of Arthur Andersen LLP, independent public
accountants, all as contained on pages 3 through 32 of the Company's 1998
Annual Report to Shareholders on Form 10-K, are incorporated herein by
reference.
ITEM 9-CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURES
None.
Part III
ITEM 10-DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
ITEM 11-EXECUTIVE COMPENSATION
ITEM 12-SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
ITEM 13-CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS
Reference is hereby made to pages 3-5, pages 8-10, page 13 and page 15 of
the Company's Proxy Statement to Shareholders dated March 18, 1999, wherein
pursuant to Regulation 14 A information concerning the above subjects
(Items 10 through 13) is incorporated by reference.
Pursuant to Rule 12b-23, definitive copies of the Proxy Statement will be
filed within 120 days subsequent to the end of the Company's fiscal year
covered by Form 10-K.
PART IV
ITEM 14-EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(1) The following consolidated financial statements, as included in the
1998 Annual Report to Shareholders, are incorporated herein by
reference:
Consolidated Balance Sheets, December 31, 1998 and December 31, 1997.
Consolidated Statements of Operations for years ended December 31,
1998, 1997 and 1996.
Consolidated Statements of Changes in Stockholders' Equity for years
ended December 31, 1998, 1997 and 1996.
Consolidated Statements of Cash Flows for the years ended December
31, 1998, 1997 and 1996.
Notes to Consolidated Financial Statements, December 31, 1998.
(2) The following exhibits are either filed or attached as part of this
report, or are incorporated herein by reference.
Exhibit Description
- -------------------------------------------------------------------------------
3.1 Restated Certificate of Incorporation of the Company
(Incorporated by reference to Exhibit B to Pre-Effective
Amendment No. 1 to Company's Definitive Proxy Statement for the
Annual Meeting of the Stockholders of the Company, filed on
April 25, 1987)
3.2 Amended By-Laws of the Company (Incorporated by reference to
Exhibit C to Company's Definitive Proxy Statement for the
Annual Meeting of the Stockholders of the Company, filed on
April 25, 1987).
4 Instruments defining the rights of security holders, including
indentures:
4.1 Specimen of the Company's Common Stock Certificate
(Incorporated by Reference to Exhibit 7 to the Company's
Registration Statement on Form S-14 (Registration Number 2-
86108) filed on August 22, 1983)
4.2 Description of the rights of holders of the Company's Common
Stock (appearing on page 9 of the Company's Registration
Statement on Form S-14 (Registration No. 2-86108) filed on
August 22, 1983)
10.1 Merchants Bancshares, Inc. Dividend Reinvestment and Stock
Purchase Plan (Incorporated by reference to Exhibit 4.1 to
Company's Registration Statement on Form S-3 (Registration No.
333-20375) filed on January 22, 1997)
10.2 401(k) Employee Stock Ownership Plan of the Company, dated
January 1, 1990, as amended (Incorporated by reference to
Company's Registration Statement on Form S-8 (Registration
Number 33-3274) filed on November 16, 1989)
10.3 Amended and Restated Merchants Bank Pension Plan dated as of
January 1, 1994 (Incorporated by Reference to Exhibit 10.6 to
Post-Effective Amendment Number 1 to Company's Registration
Statement on Form S-8 (Registration Number 333-18845) filed on
December 26, 1996)
10.5 Employment Agreement dated as of January 1, 1997, by and
between the Company, Merchants Bank and Joseph L. Boutin
(Incorporated by reference to the Registrant's Annual Report on
Form 10-K for the Year Ended December 31, 1996)
10.7 Employment Agreement dated as of January 1, 1997, by and
between Merchants Bank and Michael R. Tuttle (Incorporated by
reference to the Registrant's Annual Report on Form 10-K for
the Year Ended December 31, 1996)
10.9 Employment Agreement dated as of January 1, 1997, by and
between Merchants Bank and Thomas R. Havers (Incorporated by
reference to the Registrant's Annual Report on Form 10-K for
the Year Ended December 31, 1996)
10.11 Employment Agreement dated as of January 1, 1997, by and
between Merchants Bank and Thomas S. Leavitt (Incorporated by
reference to the Registrant's Annual Report on Form 10-K for
the Year Ended December 31, 1996)
10.12 Employment Agreement, dated as of January 1, 1998 by and
between Merchants Bank and Janet P. Spitler (Incorporated by
reference to the Registrant's Annual Report on Form 10-K for
the Year Ended December 31, 1997)
10.13 Employment Agreement, dated as of January 1, 1997, by and
between Merchants Bank and Merchants Trust Company and William
R. Heaslip (Incorporated by reference to the Registrant's
Annual Report on Form 10-K for the Year Ended December 31,
1996).
10.14 The Merchants Bank Amended and Restated Deferred Compensation
Plan for Directors (Incorporated by reference to the
Registrant's Annual Report on Form 10-K for the Year Ended
December 31, 1997)
10.14.1 Trust Under the Merchants Bank Amended and Restated
Deferred Compensation Plan for Directors
(Incorporated by reference to the Registrant's Annual
Report on Form 10-K for the Year Ended December 31,
1997)
10.15 Agreement among the Merchants Bank and Kathryn T. Boardman,
Thomas R. Havers and Susan D. Struble dated as of December 20,
1995 (Incorporated by reference to the Registrant's Annual
Report on Form 10-K for the Year Ended December 31, 1996).
10.15.1 Trust Under the Agreement among the Merchants Bank
and Kathryn T. Boardman, Thomas R. Havers and Susan
D. Struble dated as of December 20, 1995
(Incorporated by reference to the Registrant's Annual
Report on Form 10-K for the Year Ended December 31,
1996).
10.16 Agreement between the Merchants Bank and Dudley H. Davis dated
December 20, 1995 (Incorporated by reference to the
Registrant's Annual Report on Form 10-K for the Year Ended
December 31, 1996).
10.16.1 Fixed Trust under Agreement between the Merchants
Bank and Dudley H. Davis dated December 20, 1995
(Incorporated by reference to the Registrant's Annual
Report on Form 10-K for the Year Ended December 31,
1996).
10.16.2 Variable Trust under Agreement between the Merchants
Bank and Dudley H. Davis dated December 21, 1995
(Incorporated by reference to the Registrant's Annual
Report on Form 10-K for the Year Ended December 31,
1996).
11 Statement re: computation of per share earnings. See 1998
Annual Report to Shareholders Note 11.
13 1998 Annual Report to Shareholders
21 Subsidiaries of the Company
23 Consent of Arthur Andersen LLP
27 Financial Data Schedule
(3) Reports on Form 8-K: NONE
SIGNATURES
Pursuant to the requirement of Section 13 or 15 (d) of the Securities
Exchange Act of 1934 the registrant has duly caused this report to be
signed on it's behalf by the undersigned, thereunto duly authorized.
Merchants Bancshares, Inc.
Date February 18, 1999 By /s/ Joseph L. Boutin
------------------------- ---------------------------------
Joseph L. Boutin, President & CEO
Pursuant to the requirement of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of
MERCHANTS BANCSHARES, INC., and in the capacities and on the date as
indicated.
By /s/ Joseph L. Boutin By /s/ Raymond C. Pecor, Jr.
----------------------- ---------------------------------
Joseph L. Boutin, Director, Raymond C. Pecor, Jr. Director
President & CEO of the Company Chairman of the Board of
and the Bank Directors
By /s/ Peter A. Bouyea By /s/ Charles A. Davis
----------------------- ---------------------------------
Peter A. Bouyea, Director Charles A. Davis, Director
By /s/ Robert A. Skiff By /s/ Jeffrey L. Davis
----------------------- ---------------------------------
Robert A. Skiff, Director Jeffrey L. Davis, Director
By /s/ Michael G. Furlong By
----------------------- ---------------------------------
Michael G. Furlong, Director Benjamin F. Schweyer, Director
By /s/ Janet P. Spitler By /s/ Leo O'Brien, Jr.
----------------------- ---------------------------------
Janet P. Spitler, Treasurer Leo O'Brien, Jr., Director
of the Company, Vice President,
Controller, and Treasurer of the
Bank
By /s/ Patrick S. Robins
-----------------------
Patrick S. Robins, Director